Two Major Prohibitions: Riba and Gharar - Isfin fileTwo Major Prohibitions: Riba and Gharar 47 something that contains some good, legal theorists argued, it must be because of thepotentialforgreaterhiddenharm.1

3

Two Major Prohibitions: Riba and Gharar

We have shown in Chapter 2 that Islamic finance is a prohibition-driven industry.In this regard, the instigating factor for prohibition-based contract invalidationcan almost always be attributed to the two factors labeled riba and gharar. Wehave also shown in Chapter 1 that mainstream contemporary scholars of eco-nomic analysis of the law consider such prohibitions of mutually agreeable fi-nancial transactions paternalistic and conducive to efficiency losses. The form-oriented nature of Islamic finance has done little to counter this claim for Islamicprohibitions.

Participants in the industry, especially ones who are not themselves devoutMuslims, operationally respect Muslims’ religious observance and devise finan-cial solutions that avoid various prohibitions according to juristic opinion. Thisattitude has contributed further to the form-above-substance approach in Islamicfinance: Lawyers and bankers are loath to challenge jurists’ solutions as merely in-efficient replications of what they had deemed forbidden transactions. To provideproper understanding of Islamic finance as practiced today, this chapter coversthe economic substance that we believe was intended by the prohibitions. In laterchapters we shall compare the economic substance of prohibitions and premod-ern nominate contract conditions in greater detail, comparing the form-orientedapproach of contemporary Islamic finance to the substance-oriented classical ju-risprudence.

Paternalism of Prohibitions

In the process of highlighting economic substance of prohibitions of riba andgharar in this chapter, we need to address two charges against prohibitions: pater-nalism and efficiency reduction. The paternalism charge is freely admitted, sincedevout Muslims – and indeed most religious people – do not shy away from apaternalistic image of God. In this regard, Islamic jurists and legal theorists havemaintained that God never forbids anything that is good. When God forbids

46

Two Major Prohibitions: Riba and Gharar 47

something that contains some good, legal theorists argued, it must be because ofthe potential for greater hidden harm.1 For instance, the second of three Qur

˘anic

stages of gradual prohibition of wine and gambling state explicitly: “They ask youabout wine and gambling, say: ‘Therein is great sin and some benefit, and theirsin is greater than their benefit’ ” [2:219].

Human irrationality in the face of addictive activities such as drinking andgambling appears to be at the heart of this prohibition. This is suggested by theconjunction of wine and gambling in the cited verse as well as the final stage ofcategorical Qur

˘anic prohibition of addictive drinking and gambling activities:

“O people of faith: Wine, gambling, dedication of stones, and divination witharrows are abominable works of the devil. Thus, avoid such activities so that youmay prosper” [5:90].

More generally, one may consider four types of activities based on net benefitor harm: (1) beneficial ones that are apparently beneficial, (2) beneficial ones thatare not clearly beneficial, (3) harmful ones that are apparently harmful, and (4)harmful ones that are not apparently harmful. No injunctions or prohibitions areneeded for the first and third types of activities, whereas injunctions to performthe first type of acts, and prohibitions against the fourth, are necessary. In thisregard, the verse [2:219] clearly explained that drinking and gambling belong tothe fourth category: Humans may be lured by the apparent benefits and thus losesight of the greater harm.

This is easily explained in the context of drinking, which may not be harmfulin small measure, but can be extremely dangerous because of human irrationalityin the face of addictive and intoxicating substances. The intoxication effect washighlighted in the first stage of prohibition of wine: “O people of faith, do notapproach prayers while you are intoxicated” [4:43], wherein gambling was notmentioned. The addictiveness effect and resulting tendency to create acrimoniousand irresponsible behavior were highlighted by conjoining wine and gambling inthe two subsequent stages of prohibition in [2:219] and [5:90].

Bounded Rationality and Paternalism

In the case of wine and gambling, the Qur˘

anic solution was complete avoidancethereof, since those activities are not essential. In contrast, transfers of creditand risk are at the heart of finance, without which an economic system cannotfunction. The Islamic legal solution in this case was to impose restrictions on themeans of transferring credit and risk, through prohibitions of riba and gharar.In this chapter I shall argue that – in finance – the forbidden riba is essentially“trading in credit,” and the forbidden gharar is “trading in risk,” as unbundledcommodities.

48 Two Major Prohibitions: Riba and Gharar

In other words, Islamic jurisprudence uses those two prohibitions to allow onlyfor the appropriate measure of permissibility of transferring credit and risk toachieve economic ends. As many observers and practitioners in financial marketswill testify, trading in credit and risk (perfected through derivative securities) isas dangerous as twirling a two-edged sword. Although those vehicles can be usedjudiciously to reduce risk and enhance welfare, they can easily entice otherwisecautious individuals to engage in ruinous gambling behavior. While financialregulators seek to limit the scope of credit and risk trading to prevent systemicfailures, Islamic jurisprudence introduces injunctions that aim also to protect in-dividuals from their own greed and myopia.

What to Forbid? Balancing Benefits and Risks

The objective of balancing economic freedom (allowing more contracts to enablemore economic activities) with risk of abuse (if too much freedom is allowed)is made clear by the fact that some contracts that contain riba and/or gharar arepermitted in the canonical and juristic texts. This is the case with prepaid forwardsales (salam), which contain significant gharar (unnecessary risk and uncertainty),since the object of sale typically does not exist at contract time. However, thisgharar is deemed minor relative to the potential gains from financing agriculturaland other activities through salam. Thus, this benefit consideration overruled thecontract’s invalidity based on gharar, as would be dictated by analogical reasoningalone. Similarly, credit sales can easily be used as vehicles for riba, as shown inthe previous chapter (e.g., through same-item sale-repurchase, either as

˘

ina ortawarruq). In both of those examples, the benefits from allowing production ofnonexistent goods through salam, and consumption of goods against claims tofuture income through credit sales, respectively, outweigh the potential dangers ofabuse. Hence the contracts were permitted despite the corrupting factors.

The discussion in Chapter 2 of various juristic opinions on

˘

ina (same-itemsale-repurchase) is illustrative of juristic cost-benefit analysis. Obviously, one can-not forbid all spot sales or credit sales, since that would lead to economic ruin.On the one hand, jurists unanimously forbid same-item sale-repurchase if thesecond sale is stipulated in the first.2 On the other hand, if the two transactionsare executed under separate contracts, some jurists forbade the practice to pre-vent abuse (the Maliki juristic rule of preventing means of circumventing the law,known as sadd al-dhara

˘i

˘

), whereas others (e.g., Al-Shafi

˘

i, who restricted juristicreasoning to analogy) felt compelled to deem the practice valid. Of course, inIslamic finance, jurists may be asked to validate each contract separately, withoutexplaining the entire financial structure for which they will be used.

This example is indeed central for understanding our subsequent discussion ofcontemporary Islamic jurisprudence and finance. By definition, almost all novel

3 .1 The Prohibition of Riba 49

financial transactions, and variations thereof that were considered by jurists onIslamic banks’ Shari

˘

a boards, are sufficiently complex to generate multiple juris-tic opinions based on analogy, prevention of abuse, benefit analysis, and the like.Variations in opinions allow Islamic financial providers to exercise price discrim-ination by segmenting the market according to degree of conservatism, therebyextracting greater Shari

˘

a arbitrage rents from more conservative customers.

3 .1 The Prohibition of Riba

The three-letter past-tense root of the term riba is the Arabic verb raba, meaningto increase.3 Therefore, jurists defined the forbidden riba generally as “tradingtwo goods of the same kind in different quantities, where the increase is not aproper compensation.”4 Naturally, the lexical meaning of the term (which coversincrease of all types) is not the object of prohibition. Thus, numerous jurists haveanalyzed the juristic meaning of the forbidden riba over the centuries. While mostcontemporary jurists have denied any uncertainty about the juristic definition offorbidden riba, studies such as the two in Rida (1986) clearly show that premod-ern and contemporary jurists have expanded the definition of the forbidden ribaconsiderably beyond its original domain.5

In this regard, the distinction between legitimate compensations and forbid-den riba is the most fundamental distinguishing feature of Islamic finance, as aprohibition-driven industry. However, the distinction – as defined by contempo-rary jurists – is exploited mostly by adopting premodern forms rather than mech-anisms that ensure fairness of contract pricing. In this regard, understanding thecanonical prohibition of riba, and contemporary interpretations thereof, is centralto understanding the industry as it exists today, as well as any likely alternative “Is-lamic” structure. We thus turn now to the task of providing an economic analysisof the canonical texts on riba and the classical juristic analyses thereof. We beginby considering the canon.

Canonical Texts on Riba

There are two main types of riba recognized by all scholars, with Shafi

˘

i scholarsproviding a further refinement of the second type. The first type is called ribaal-nasi

˘a.6 The worst form of this riba, known as riba al-jahiliyya (practiced in

pre-Islamic Arabia), was strictly forbidden in the Qur˘

an, to the point that ImamMalik is reported to have described its prohibition as the severest one in Islam.7

The first mention of riba in the Qur˘

an was in Makka, and it discouragedcollection thereof, without explicitly prohibiting it: “That which you lend toincrease in the property of others will not increase with God; but that which


you give out in charity, seeking God’s pleasure, it will surely multiply” [30:39].The first verses regarding riba that were revealed in Madina only forbade pre-Islamic riba of Arabia, whereby interest was charged at the maturity of debts frominterest-free loans or credit sales, and compounded at later maturity dates. Thus,the principal due on the debtor was described in the Qur

˘an as “riba doubled and

multiplied” [3:130].8 Among the very last Qur˘

anic verses to be revealed, theverses [2:275–9] ordered Muslims to abandon all remaining riba (presumably ofthe same form defined in [3:130]), otherwise to expect a war from God and HisMessenger.

Main Juristic Taxonomies of Riba

Most jurists have expanded the strict Qur˘

anic prohibition of pre-Islamic riba tocover all forms of interest-bearing loans, subsumed under the term riba al-nasi

˘a.

They provided three explanations of the rationale for this prohibition: (1) onemight potentially exploit poor debtors who need to borrow money or commodi-ties, (2) trading money may lead to fluctuations in currency values and monetaryuncertainty, (3) trading foodstuffs for larger amounts of future foodstuffs wouldlead to shortages in spot markets for those foodstuffs (presumably because manytraders would withhold the goods in the hope of getting more in the future!).9

None of those explanations seems particularly convincing. After all, a usurercan equally easily exploit a needy debtor by selling him a property of market value$100, say, for a deferred price of $1,000, without violating the rules of riba asenvisioned by jurists. The second explanation seems equally weak on economicgrounds. Relative prices of commodities may fluctuate based on supply and de-mand changes, regardless of the possibility of extending interest-based credit.

Finally, the logic of the argument on foodstuffs is clearly defective: Tradersprefer deferment only as long as the terms of trade exceed their time preferenceand vice versa – indeed, that is how implicit interest rates would be determinedin equilibrium, based on market participants’ rates of time preference. Moreover,if credit trading in foodstuffs could cause the problems of which classical juristsspoke, those same problems would result from selling deferred claims on food-stuffs for an immediate monetary price, or selling foodstuffs for deferred mone-tary prices, both of which are allowed by jurists with implicit compensation fortime value. In fact, jurists of all major schools, declaring that “time has a share inthe price,” recognized the legitimacy of seeking compensation for time value incredit and salam sales, including where the objects of sale are foodstuffs.10

The second category of riba recognized by jurists is called riba al-fadl (the ribaof increase, also called riba al-Sunna). It prohibits trading goods of the same genusand kind in different quantities, based on a valid Prophetic tradition: “Gold forgold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt


for salt, like for like, hand to hand, and any increase is riba.”11 Non-Zahiri juristsagreed that those six commodities were given only as examples. Hanafi juristsextended the prohibition to all fungible goods measured by weight or volume,whereas Shafi

˘

i and Maliki jurists restricted it to monetary commodities (goldand silver) and storable foodstuffs.

In our discussion of currency exchanges (sarf ), we shall discuss Prophetic tradi-tions that dealt exclusively with spot- and deferred-price trading of gold for gold,silver for silver, and gold for silver. Those traditions explicitly forbade a standardtrick used by Medici bankers to circumvent the early Catholic Church’s prohibi-tion of interest, by subsuming interest rates in exchange rates.12

Riba Is Not the Same as Interest

There are reports that some prominent early companions of the Prophet, includ-ing the brilliant jurist

˘

Abdullah ibn˘

Abbas, did not recognize the strict prohibi-tion of riba that does not involve a time factor. He, Usama ibn Zayd ibn Arqam,Ibn Jubair, and others ruled that the only type of definitively forbidden riba isthat which contains a time factor (riba al-nasi

˘a), even citing a Prophetic tradition

to that effect: “There is no riba except with deferment.”13 Later reports by Jabirsuggest that this tradition referred to trading different goods, such as gold for sil-ver or wheat for barley, and that Ibn

˘

Abbas reversed his opinion and joined themajority opinion of prohibition of riba al-fadl.14

Jurists listed two reasons for the prohibition of riba al-fadl, which does notinclude a time factor: (1) spot trading of the same commodity for different quan-tities can be easily combined with credit sales to bring about the same effect asdeferment riba (hence riba al-fadl is forbidden to prevent circumvention of thelaw – saddan lil-dhara

˘i

˘

), and (2) such trading includes excessive gharar (avoidablerisk and uncertainty), since neither party knows whether the trade is beneficial orharmful to them.15 Ibn Rushd based his central analysis of riba, on which weshall elaborate below, on the latter explanation of the prohibition (uncertaintyregarding equity in exchange).

The inclusion of riba al-fadl under the general heading of forbidden riba is veryimportant for understanding the economic substance of the prohibitions. How-ever, most contemporary jurists and scholars of Islamic finance wish to excludediscussions of this topic, precisely to continue the mistaken one-to-one rhetoricalassociation of “riba” with “interest.” In fact, equivalence of the two terms is farfrom appropriate.

First, even the most conservative contemporary jurists do not consider all formsof what economists and regulators call interest to be forbidden riba. A simpleexamination of riba-free Islamic financial methods such as mark-up credit sales(murabaha) and lease (ijara) financing shows that those modes of financing are


not “interest-free.” Indeed, truth-in-lending regulations in the United States forceIslamic and conventional financiers to report the implicit interest rates they chargetheir customers in such financing arrangements. Thus, the practice of Islamicfinance itself illustrates the fact that some forms of interest (e.g., in credit salesand leases) should not be considered forbidden riba.

Conversely, the prohibition of riba al-fadl illustrates definitively that there areforms of forbidden riba (illegitimate increase in exchange) that do not include in-terest. Indeed, as some Hanafi jurists have noted, the six-commodities Prophetictradition cited in the previous section stipulated two conditions: “hand to hand”and “in equal amounts.” Thus, if one traded an ounce of gold today for a de-ferred price of one ounce of gold next year, the transaction would still be deemedriba, despite the zero interest rate, because of violation of the “hand-to-hand”restriction. Those Hanafi jurists reasoned as follows: An ounce of gold today isclearly worth more than an ounce of gold in one year (recognizing the time valueof money). Thus, one would never trade an ounce of gold today for an ounce ofgold next year, unless one is getting something else in return (which is not dis-closed in the sales contract). Whatever that extra benefit may be, they argued, itconstitutes riba. Our subsequent analysis of the prohibition of riba – in termsof ensuring economic efficiency and equity in exchange – would simply explainthe prohibition at zero interest based on the same general principle, applied toany other interest rate: How do we know that zero percent is the fair rate inexchanging gold today for gold in one year?

Economic Substance of the Prohibition of Riba

In his seminal work on comparative jurisprudence, the Maliki jurist, judge, andphilosopher Ibn Rushd (also known as Averroës, d. 595 A.H./1198 C.E.) adoptedthe Hanafi generalization of rules of riba (based on the six-commodities tradition)to all fungible commodities, based on the following economic analysis:

It is thus apparent from the law that what is targeted by the prohibition of riba is the ex-cessive inequity it entails. In this regard, equity in certain transactions is achieved throughequality. Since the attainment of equality in exchange of items of different kinds is difficult,we use their values in monetary terms. Thus, equity may be ensured through proportion-ality of value for goods that are not measured by weight and volume. Thus, the ratio ofexchanged quantities will be determined by the ratio of the values of the different types ofgoods traded. For example, if a person sells a horse in exchange for clothes ... if the valueof the horse is fifty, the value of the clothes should be fifty. [If the value of each piece ofclothing is five], then the horse should be exchanged for 10 pieces of clothing.

As for [fungible] goods measured by volume or weight, equity requires equality, since theyare relatively homogenous, and thus have similar benefits. Since it is not necessary for a


person owning one of those goods to exchange it for goods of the same type, justice in thiscase is achieved by equating volume or weight, since the benefits are very similar.16

Thus, Ibn Rushd articulated the conditions for efficiency in exchange: that theratio of traded quantities should be determined by the ratio of prices, and thelatter should be equal to the ratio of [marginal] utilities.17 This restriction wasnever made part of the rules of riba, since monitoring market prices of all goodswould be a very tedious task. Thus, the prohibition is imposed only for equality inexchanging fungible goods, with the understanding – as suggested by Ibn Rushd –that if significant quality differences existed, one would avoid directly exchanginglow-quality goods for high-quality ones of the same kind in barter.

A number of Prophetic traditions clearly support the notion of equity throughequality when trading fungibles and illustrate the alternative of avoiding directbarter in cases of different good qualities. In this regard, Bilal and Abu Hurayrahnarrated that a man employed in Khaybar brought the Prophet some high-qualitydates. The Prophet inquired if all Khaybar dates were similar to that kind, andthe man told him that they traded two or three volumes of lower-quality datesfor one volume of higher-quality ones. The Prophet told him – angrily – neverto do that again, but to sell lower-quality dates and use their proceeds to buy thehigher-quality ones.18

Equity and Efficiency through Marking to Market

Selling the first type of dates (at the highest available market price), and buyingthe other type (for the lowest available market price), ensures that exchange takesplace at the ratio dictated by market prices. Naturally, traders would trade only atthat ratio if they valued the marginal units differently. Allowing for diminishingmarginal utilities, whereby the buyer of each type of dates will value successivemarginal units less, trading eventually halts by equating the ratio of marginalutilities to the ratio of market prices. Hence (Pareto) efficiency in exchange isattained, as dictated by contemporary neoclassical economic theory. Thus, theinjunction against this type of riba al-fadl can be readily seen as a mechanismthat precommits those who observe the prohibition to collection of informationabout market conditions, and marking terms of trade to market prices. This pro-tects individuals against engaging in disadvantageous trades and enhances overallexchange efficiency. In this regard, notice that trading at any ratio that deviatesfrom that of market prices will – by necessity – be disadvantageous to one party.Hence, justice and efficiency both dictate following this mark-to-market approachto establishing trading ratios.

Extending this logic to exchange over time (through credit sales, leases, or othertransactions) is not difficult. In the context of credit sales and lease-to-purchase fi-


nancing, the substantive prohibition of riba – aiming to ensure equity in exchange– dictates that credit in such transactions must be extended at the appropriate in-terest rate. In this regard, conventional finance has played a very important rolefor contemporary Islamic finance, by determining the market interest rates forvarious borrowers, based on creditworthiness and security of the posted collateral.

Here, benchmarking the implicit interest rate in Islamic credit sales and lease-to-purchase transactions to conventional interest rates is quite appropriate. In-deed, if, for instance, the market interest rate for a particular borrower and par-ticular collateral was 6 percent, but customer and financier agreed on a credit saleat 10 percent implied interest, one would object that this clearly violates the spiritof Islamic prohibition of riba, even if it uses a sale-based ruse to stay clear of theancient forbidden form. In this regard, Al-Misri (2004) has argued that Islamicbanks are well advised to abandon characterizing their mark-up in credit sales as“profit,” and list it instead as “interest,” since the former is potentially unlimitedwhereas the latter is capped by various contemporary anti-usury laws that protectthose in need of credit against predatory lenders.

Islamic Finance: Form and Substance Revisited

Why, then, would we need an Islamic finance? Why would we go through thetrouble of forcing an Islamic bank to buy a property first and then sell it to thecustomer on credit if the actual objective can be achieved more directly, through asecured lending transaction? Those questions must be answered in two steps: Thefirst step is recognition that individuals engage in myopically excessive borrowingbehavior if left to their own devices. Adherence to religious law can serve as aneffective precommitment mechanism to ensure that individuals do not abuse theavailability of credit to their own detriment.

The second step is recognition that adherence to religion has been historicallyensured through adherence to forms, equally in the areas of ritual and transac-tions. In this regard, classical jurists developed contract forms and conditionsthereof in a manner that encapsulated the spirit of the law to the best of their abil-ity. When contemporary jurists attempt to help Muslims adhere to the spirit ofthe law, they feel safest working within the formal and informal methodologies ofIslamic jurisprudence. We have seen in earlier chapters that Islamic jurisprudenceis in fact a common-law system (if dressed in the garb of canon law), with em-phasis on precedent and analogy. The resulting contemporary process of adaptingclassical contract forms to modern needs necessarily produces interim inefficiency.

This inefficiency would be tolerable only if we ensure that the spirit of the Lawthat gave rise to adopted forms is protected. Otherwise, it would be shamefulmerely to copy or adapt inefficient historical forms and squander the substance ofIslamic law. Ideally, contemporary jurists would develop a modern jurisprudence


that embodies the substance of premodern laws within the context of contempo-rary legal and regulatory frameworks. This ideal may be approachable in the longterm but seems impossible in the short term. In this regard, earlier jurists hadthe luxury of seeking efficiency by adopting Roman or other legal forms. How-ever, later jurists have to work under the heavy burden of sacred history, includingunreasonable admiration of the presumed timeless wisdom of their predecessors.Thus, practical Islamic solutions for the short to medium term may abandon pre-modern forms only gradually.

Multiple Paternalistic Parties

Earlier in this chapter, we discussed the paternalistic nature of prohibitions in gen-eral. We now turn to the prohibition of riba in particular, which aims substan-tively to protect individuals from getting excessively indebted, as well as paying orreceiving unfair compensations for receipt or extension of credit. Naturally, onemight argue that secular regulators also strive (paternalistically, one might add) toprevent individuals from borrowing excessive amounts, or falling prey to unfairpredatory lending. However, regulators care primarily about the general health ofthe financial system – their concern about financial health of specific individualsbeing secondary at best. Thus, regulators may allow certain types of transactionsthat are hazardous to a few individuals, based on the tradeoff between that partic-ular group’s well-being (which is not their primary mandate) and overall systemicwell-being (e.g., economic growth).

A second group of economic agents who aim to prevent excessive indebted-ness are bankers, who use debt payments relative to income and other criteria forcredit extension. However, bankers and loan officers work primarily for financialcorporations that care little about systemic or individual financial health and caremostly about their own profitability. Thus, they would generally allow large num-bers of customers to borrow excessively if the expected rate of repayment remainssufficiently high to ensure profitability.

Human Time Inconsistency and Precommitment Solutions

Thus, restrictions imposed by regulators and financial professionals require sup-plementary protections for individuals against their own irrational behavior – afunction that can be fulfilled by religious law. In this regard, it is well documentedin psychological and behavioral economic research that humans exhibit funda-mental forms of irrationality in time preference, against which precommitmentmechanisms (including those based on religion) can protect them. For instance,most individuals would prefer $100 today over $105 in one year, but prefer $105in twenty years over $100 in nineteen. Those and other “time preference anoma-


lies” suggest that individuals will be “dynamically inconsistent” in their saving,spending, and borrowing behavior.19

The conclusion of this research is that individuals tend to discount the imme-diate future (e.g., one year from now) much more severely than they discountover a similar period later in the future (e.g., between nineteenth and twentiethyears). Thus, in the previous example, an interest rate of 5 percent looks low forthe current year, but sufficiently high for an arbitrary year further in the future.An individual exhibiting this type of time preference will choose to borrow $100today, planning (genuinely) to save in the future and pay off his loan. However,once the future arrives, present consumption is again valued substantially morethan future consumption, and the individual borrows even more, under the illu-sion that he will later save enough to pay off both loans. The debt cycle neverends. Some of those individuals may experience sufficiently fast growth in theirincomes, so that they can eventually pay off their debts without increasing theirsaving rates. However, many other debtors may get buried under a debt cycleand eventually have to declare personal bankruptcy, which has become a mini-epidemic in some Western societies.

Good Loans and Bad

Why, one may wonder, would banks extend those bad loans that lead to bankrupt-cies? The answer is that loans are very rarely bad at their inception. When eco-nomic conditions are favorable, many borrowers experience income growth, andbanks have an incentive to continue lending to them, since the number of de-faults and bankruptcies will be too small to affect their profits. Sometimes, forexample, in Asia during the 1990s, borrowed funds are invested in real estate andother fast-appreciating assets, making loans that are secured by those overpricedassets seem less risky than they are in reality. As economic conditions worsen, andasset market bubbles burst, too many of those loans may turn bad simultaneously,threatening the financial system. Hence, regulators impose restrictions to ensurethat banks’ operations do not threaten the system, albeit in a reactive manner thatoften fails to protect against later banking crises. In contrast, religious law aims toprotect each and every individual by ensuring that they do not borrow excessively.

For instance, consider a Muslim customer who wishes to finance a home pur-chase through lease financing. If the housing market in question happens to beexperiencing a speculative bubble, that fact should become clear to the customerby comparing the “rent” he would have to pay his Islamic bank (which is bench-marked to mortgage market interest rates) to the actual market rent of the prop-erty. If mortgage payments are excessively high relative to rent, that is generally


an indication that the customer is about to borrow an excessive amount of moneyrelative to the long-term value of the property serving as collateral. Thus, markingthe interest rate to market lease rates should prevent the individual from engagingin excessive borrowing to purchase that property. In the process, the customeris also assured that the implicit interest rate he pays is marked to the market-determined time value of the property serving as security for the debt.

If such considerations are ignored, the Islamic bank in this example wouldmerely allow the customer to become “house-poor” or bankrupt, but do it “Is-lamically” through partial adherence to classical contract forms. That would beshameful abuse of religion and finance. Consequently, although we have acceptedthe necessary inefficient Islamic financial adherence to classical contract forms, itis equally if not more important to ensure adherence to the substance of Islamiclaw, which premodern jurists attempted to enshrine in those classical forms.

Digression on Loans in Islamic Jurisprudence

We have thus seen that the classical prohibition of riba in finance refers to theunbundled sale of credit, wherein it is difficult to mark the interest rate to market.In this regard, the simplest form of an unbundled credit sale is an interest-bearingloan. Indeed, if loans were viewed as commutative financial contracts (i.e., if re-payment of the loan were viewed as compensation for the lent amount), then eveninterest-free lending would have been deemed forbidden riba. Al-Qarafi arguedin Al-Furuq (a legal-theory book dedicated to explaining juristic distinctions) thatlending is exempted from the rules of riba because of its charitable nature. Re-ligiously, one who extends a loan does not seek repayment as the compensation,but rather seeks to give the time value of lent money, or usufruct of lent property,in charity.20

Thus, the Prophet’s companions and early jurists said that they preferred tolend a coin, have it repaid, and lend it again, rather than to give it away in charity.Goodly loans have direct charity built in, as a needy debtor would be absolvedif he cannot pay. On the other hand, a needy borrower retains dignity relativeto recipients of explicit charity, through the possibility of repaying the principal.Even in case of repayment, the lender gains religious credit through sacrificing thetime value of his property, and proving his willingness to sacrifice the propertyitself if necessary. Hence, Islamic jurisprudence excluded lending from the arenaof finance, to retain its goodly charitable nature. This is possible since all thefinancial ends that can be served through commercial lending can be equally ifnot better served through other forms of commutative contracts (such as sales,leases, and the like).


3 .2 The Prohibition of Gharar

We have explained prohibitions in terms of boundedly rational human behavior,in particular with regard to highly addictive behavior such as drinking and gam-bling. In particular, we have argued that the prohibition of riba may very wellbe based on the potentially addictive nature of borrowing and living beyond one’smeans. In this section we deal with the prohibition of gharar, which was charac-terized by prominent jurists in light of its similarity to gambling. In this regard,the late Professor Mustafa Al-Zarqa defined the forbidden bay

˘

al-gharar as “thesale of probable items whose existence or characteristics are not certain, the riskynature of which makes the transaction akin to gambling.”21

Numerous historical examples of forbidden gharar sales are enumerated in clas-sical jurisprudence books.22 Generally speaking, gharar encompasses some formsof incomplete information and/or deception, as well as risk and uncertainty in-trinsic to the objects of contract. Since complete contract language is impossible,some measure of risk and uncertainty is always present in contracts. Thus, ju-rists distinguished between major or excessive gharar, which invalidates contracts,and minor gharar, which is tolerated as a necessary evil. In his seminal papersummarizing classical opinions on gharar and applying them to contemporarytransactions, Professor Al-Darir listed four conditions for gharar to invalidate acontract.23

First, gharar must be excessive to invalidate a contract. Thus, minor uncer-tainty about an object of sale (e.g., if its weight is known only up to the nearestounce) does not affect the contract. Second, the potentially affected contract mustbe a commutative financial contract (e.g., sales). Thus, giving a gift that is ran-domly determined (e.g., the catch of a diver) is valid, whereas selling the sameitem would be deemed invalid based on gharar.24 This condition is extensivelyused in designing takaful (cooperative insurance) as an alternative to commer-cial insurance solutions. Takaful companies, stockholder and mutually owned,use noncommutativity structures of voluntary contribution (tabarru

˘

) and agency(wakala), respectively, to resolve the gharar problem on the basis of which mostcontemporary jurists forbade commercial insurance. We shall discuss those struc-tures in greater detail in Chapter 8.

Third, for gharar to invalidate a contract, it must affect the principal compo-nents thereof (e.g., the price or object of sale). Thus, the sale of a pregnant cowwas deemed valid, even though the status of the calf may not be known. Indeed,the price of a pregnant cow would be higher than the price of the same cow if itwere not pregnant. However, the sale of its unborn calf by itself is not valid basedon gharar. In the first case, the primary object of sale is the cow itself, whereasin the latter case the object of sale is the unborn calf, which may be still-born.

3 .2 The Prohibition of Gharar 59

Finally, if the commutative contract containing excessive gharar meets a need thatcannot be met otherwise, the contract would not be deemed invalid based on thatgharar. A canonical example is salam (prepaid forward sale), wherein the object ofsale does not exist at contract inception, giving rise to excessive gharar. However,since that contract allows financing of agricultural and industrial activities thatcannot be financed otherwise, it is allowed despite that gharar. Similarly, whilecontemporary jurists forbade commercial insurance based on excessive gharar andavailability of noncommutative (takaful) alternatives, they currently allow taka-ful companies to deal with conventional reinsurance companies, since re-takafulalternatives are not yet available.

Definition of Gharar

The distinction between major and minor gharar, as well as considerations in thefourth criterion for gharar to invalidate contracts, suggests a strong cost-benefitanalysis as the foundation for prohibition. Indeed, a number of classical juristsexplicitly highlighted this central cost-benefit analysis:

[The Prophet’s] prohibition of gharar sales (bay

˘

al-gharar) render such sales defective. Themeaning of “gharar sale,” and God knows best, is any sale in which gharar is the majorcomponent. This is the type of sale justifiably characterized as a gharar sale, and it is unan-imously forbidden. However, minor gharar would not render a sales contract defective,since no contract can be entirely free of gharar. Consequently, scholars differ in opinionregarding which contracts are thus rendered defective, based on their assessment of the ex-tent of gharar in the contract. Thus, each scholar would invalidate a contract if he deemsits gharar component substantial, and would otherwise declare the contract valid if thegharar is deemed minor.25

Scholars said that the criterion for invalidity of a contract based on gharar, or validitydespite the existence of gharar, is this: If necessity dictates allowing gharar, which thus can-not be avoided without incurring an excessive cost, or if gharar is trivial, the sale is deemedvalid, otherwise it is deemed invalid. . . . Thus, differences in opinion among scholars arebased on this general principle, where some of them render a particular form of gharar mi-nor and inconsequential, while others render the same form substantial and consequential,and God knows best.26

In this regard, the corrupting factor in gharar is the fact that it leads to dispute, hatred,and devouring others’ wealth wrongfully. However, it is known that this corrupting factorwould be overruled if it is opposed by a greater benefit.27

Perhaps the best literal and juristic translation for “bay

˘

al-gharar” is “trading inrisk.”28 In this regard, the Encyclopedia of Islamic Jurisprudence also lists cheating(tadlis) and fraud (ghubn) as special cases of gharar.29 Thus, gharar incorporates


uncertainty regarding future events and qualities of goods, and it may be theresult of one-sided or two-sided and intentional or unintentional incompletenessof information.

The factor that is common in all those categories is significant (possibly un-quantifiable) risk and uncertainty. The possibility of unanticipated loss to at leastone party may be a form of gambling or may lead to ex post disputation betweencontracting parties. The prohibition of bay

˘

al-gharar (the sale of gharar) may thusbe seen as a prohibition of the unbundled and unnecessary sale of risk. Of course,the most extreme form of unbundled sale of risk is gambling: paying a prede-termined price for some unproductive game of chance (e.g., spinning a roulettewheel and winning a larger sum of money if the ball falls on black). Various formsof gharar are assessed based on proximity to this extreme form.

Economic Substance of Prohibition

The most significant developments in finance over the past three decades havebeen in the area of separating various financial credit and risk components foraccurate pricing. This was accomplished through advances in securitization anddevelopment of financial derivatives. We admitted earlier that finance (Islamic orotherwise) is about allocation of credit or risk. Moreover, we have argued thatthe two main prohibitions in Islamic jurisprudence, those of riba and gharar, arebest characterized as trading in unbundled credit and trading in unbundled risk,respectively. For the case of riba, we argued that disallowing unbundled tradingof credit can protect individuals who are vulnerable to excessive borrowing fromfalling into debt cycles and ensured marking interest rates to market. Similarly, itcan be seen that the prohibition of trading unbundled risk aims to protect indi-viduals from exposure to excessive financial risk or payment of mispriced premiato eliminate existing risks.30

Bounded Rationality in the Face of Risk

Starting with the early experiments by Allais in 1953, behavioral economists andpsychologists have documented a number of basic patterns in human behaviorunder risk and uncertainty. Kahneman and Tversky (1979) summarized the mostimportant patterns under four headings, the most important being (1) the exces-sive weight humans place on events considered certain, relative to ones that arehighly probable, (2) the overweighting of losses compared to gains, and (3) risk-loving behavior over losses. A recent literature has emerged in finance, using thosedocumented idiosyncrasies of human behavior under risk to provide explanationsfor a host of otherwise puzzling human and market behaviors.31

3 .2 The Prohibition of Gharar 61

The above-mentioned idiosyncrasies drive individuals to take too much risk,and then to pay too much for insurance. For instance, when one buys a com-puter at a retail store in the United States, the computer commonly comes withonly a one-year manufacturer’s limited warranty. At the check-out, just before onepays for the computer, the sales clerk offers the buyer an extended warranty. Thisinsurance sales tactic is used to capitalize on individuals’ loss aversion. If the in-surance was offered bundled with the computer (e.g., if it sold for $1,000 withoutwarranty, and for $1,200 with extended warranty), buyers will tend to view safetyas an attribute of a computer they do not yet own, and would thus be unwillingto pay a high price for the embedded insurance. In contrast, once the buyer isready to pay for the computer, thus considering it his property, loss aversion willdrive him to pay more for insurance than he would have otherwise.

Some experimental evidence suggests that financial professionals are no lesssusceptible to those documented human idiosyncrasies in decision making underrisk and uncertainty.32 Most humans seem to exhibit loss aversion or asymmetricassessment of small gains versus small losses. This loss aversion produces willing-ness to pay too much for insurance, once the new “reference point” – with respectto which “prospects” are evaluated – makes one think of more events in termsof loss. In addition, since humans also tend to exhibit risk-loving behavior overlosses and risk-averse behavior over gains, they treat the same prospect differently,depending on how it is presented to them. Those human idiosyncrasies in deci-sion making under risk and uncertainty lead to dynamically inconsistent behavior.Precommitment, through prohibition of selling the unbundled insurance, helpsto protect consumers against that dynamic inconsistency.

Insurance and Derivatives

If we accept the definition of forbidden bay

˘

al-gharar as trading in risk, we canreadily understand contemporary jurists’ prohibition of conventional insuranceand derivatives trading. Those topics will be discussed in much greater detail inChapter 8. Thus, our coverage in this chapter only briefly links juristic analysisof the prohibition of gharar to our economic understanding of its legal substance.In this regard, we have noted in Chapter 2 that jurists argued that “safety” or“insurance” itself does not qualify as the object of sale. Hence, the object ofsale in that contract would have to be defined as a contingent claim, akin to anoption: The insured party has a legal right to receive compensation for damagesin the event of loss stipulated in the insurance contract.

Based on this interpretation, jurists have forbidden commercial insurance date-ing back to the late nineteenth century C.E., when the prominent Hanafi juristIbn

˘

Abidin, whose work and opinions were central to the Ottoman Majalla,


forbade maritime insurance on similar grounds. Likewise, jurists forbade nakedoptions (calls and puts), which give their holders a legal right (respectively, to buyor sell the underlying assets). In this regard, the legal right to exercise the optionwas also viewed to be ineligible as object of sale. Thus, in both insurance andoptions, the price (insurance premium or option price) is certain, but its com-pensation (insurance payment or profit from exercising option) is uncertain, andhence the trade is forbidden based on gharar.

Notice that, in both instances, it is the sale of an unbundled contingency claimor legal right that jurists have forbidden. Jurists have not forbidden the inclusionof warranty in sale, whether the warranty is provided by the manufacturer orthe retail seller. This bundled sale of insurance was allowed, just as the bundledsale of credit was (e.g., by allowing a manufacturer or dealer to sell cars withdeferred payments, whereas financially equivalent loans are considered forbiddenunbundled sales of credit). Likewise, jurists have not forbidden the sale of bundledoptions. Indeed, juristic analyses of sales contracts include lengthy discussions ofpermissible options in sales, an area in which the highly respected Hanbali juristsIbn Taymiyya and his student Ibn Qayyim were particularly liberal.

3 .3 Bundled vs. Unbundled Credit and Risk

We have thus argued that the two major prohibitions in Islamic jurisprudenceof financial transactions, those against riba and gharar, are in fact prohibition oftrading in unbundled credit and unbundled risk, respectively. We have furtherargued that the paternalistic nature of those prohibitions is understandable, inlight of human idiosyncrasies that would lead to dynamically inconsistent behav-ior, much like wine drinking can lead to dynamically inconsistent behavior formost humans. Unlike the consumption of intoxicating beverages, which is notnecessary for life, transfer of credit and risk is fundamental to the functioning offinancial systems and economies. Hence, classical jurisprudence evolved meth-ods of bundled trading in credit and risk while maintaining the prohibition ofunbundled trading thereof.

That being said, one must recognize that classical contract forms – specificmeans of bundling credit and/or risk with other economic activities – can be usedas apparently legitimate means toward illegitimate ends. This is obviously the casein tawarruq, for instance, where the stated purpose is to extend credit and provideliquidity to some customer. Economic activities camouflaging the underlying saleof credit (two spot sales and one credit sale of some commodity) do little to protectindividuals from borrowing or lending excessively, for the wrong reasons, or at thewrong interest rate.

3 .3 Bundled vs. Unbundled Credit and Risk 63

In the case of legitimate credit sales or lease-to-purchase financing secured byreal estate, vehicles, equipment, and the like, marking-to-market rental value ofthe financed instrument can help individuals and lenders determine whether ornot the implicit loan is justifiable. In contrast, the “rental” value on commoditiesused in tawarruq is precisely the rental value on money: that is, market interestrates that are not linked to the object of sale in any meaningful way. In otherwords, the “bundling of credit” in this transaction serves no economic purpose.It is a mere legal stratagem or ruse (hila) to legalize otherwise forbidden interest-based lending. That is why jurists of most schools have forbidden this transaction,which takes the form of multiple valid sales but does not serve the desired sub-stance of Islamic law.

In later chapters we shall see that some classical nominate contract-based solu-tions to the prohibitions of riba and gharar seem to serve the form and substanceof classical jurisprudence, while others clearly do not. In cases where currentpractice in Islamic finance serves legal form alone, and ignores substance, we haveseen the credibility of the industry erode (e.g., in scholarly and public attacks onthe contemporary practice of murabaha financing as merely inefficient lending).33

This in turn led to the development of better alternatives (e.g., increased use oflease-based financing, including in sukuk issuances, in which marking-to-marketrent is more straightforward). By attempting to analyze forms and economic sub-stance of classical jurisprudence simultaneously, we hope to make it easier forindustry participants to develop instruments that serve the latter. In the longerterm, that emphasis on the economic substance of transactions may eventually ridIslamic finance of outdated and inefficient modes of operation. Thus, the Islamicbrand name of the industry may be redefined in terms of consumer protectionand social development, rather than contract mechanics.

4

Sale-Based Islamic Finance

As noted in earlier chapters, nominate contracts in classical Islamic jurisprudenceplay a very prominent role in contemporary Islamic finance. This prominence isin large part a function of the common-law nature of Islamic jurisprudence. Con-temporary jurists are generally reluctant to declare that a contemporary financialpractice is permissible under Islamic law, even though the default rule in transac-tions is permissibility. Thus, jurists seek precedents in classical jurisprudence tojustify proposed contemporary practices.

To illustrate, consider the Chapter 1 example of conventional mortgage loantransaction and the Islamic version based on murabaha financing. Backgroundcredit checks, and other financial considerations to determine whether or notcredit should be extended to a particular customer, are identical in both settings.Indeed, the mark-up charged to a customer under the Islamic model can be de-termined based on the customer’s credit rating and benchmarked to interest rateson potential conventional loans to the customer. The main difference betweenconventional and Islamic financing procedures is thus inherent in the contractsused.

In the case of conventional mortgage lending, the bank collects principal plusinterest on debt documented as a loan. In contrast, the murabaha model of Is-lamic finance is predicated on the permissibility of charging a credit price that ishigher than the spot price of a property. Thus, the Islamic bank collects principalplus interest on debt documented as a credit price. As noted previously, the pricemark-up can mimic conventional interest rates, and indeed the amortization tablefor a murabaha financing facility may be identical to the corresponding table fora mortgage loan. However, the murabaha financing return on capital is charac-terized rhetorically as profit or price mark-up in a sales transaction rather thaninterest on a loan.

One problem in applying the credit sale murabaha model directly to mortgagefinancing is that the bank does not own the property it finances. In fact, most

64

4.1 Basic Rules for Sales 65

banks in the West are prevented from owning real estate or trading it. Thus, theIslamic model requires that the bank must first purchase the property (possiblythrough a special-purpose vehicle) and then sell it (or lease it then sell it, in ijarafinancing) to the customer. This imposes a number of additional transactioncosts, including legal fees and sales taxes.

Some of those costs may be reduced by lobbying regulators. For instance, theFinancial Services Authority (FSA) recently made murabaha financing, for exam-ple, as practiced in the United Kingdom by HSBC, more affordable by eliminat-ing double-duty taxation when the two sales are executed to facilitate financing.1

Other costs can be reduced by allowing the customer to act as the bank’s agent,thus buying the property on the bank’s behalf and then selling it to himself. Thoseand other steps allow the Islamic model progressively to approximate the conven-tional model’s procedures and costs.

Islamic finance as practiced today serves a primary goal of replicating conven-tional financial products and services, as efficiently as possible, utilizing classicalcontract forms (such as sales and leases). Toward the end of enhancing efficiencyin Islamic finance, bankers and lawyers venturing in the field need to understandsome of the basic features of classical nominate contracts, which are used to mimicconventional financial products and services. However, one can hope that as theindustry matures, its practitioners will look beyond mimicking contemporary fi-nancial practices utilizing those classical contract forms. As we review the mainclassical contract forms, we should reflect on our Chapter 3 analysis of the mainprohibitions in Islamic financial jurisprudence, their economic merit, and the wayclassical nominate contracts implemented the principles enshrined in the jurispru-dence. This can help in our quest for a thoroughly contemporary Islamic financialmodel that retains the substance of classical jurisprudence, rather than falling intosuperficial adherence to classical contract forms while possibly violating the sub-stance of Islamic law.

4.1 Basic Rules for Sales

Sale is the ultimate permissible contract, as indicated by the Qur˘

anic verse as-serting that God has permitted trade and forbidden riba [2:275]. Sales generallyare characterized by classical jurists as exchanges of owned properties, includingservices and some property rights for non-Hanafi jurists. A sales contract requiresoffer and acceptance, with a meeting of minds for buyer and seller. For Hanafisand Malikis, a sale is concluded and binding on both parties on the expressionof offer and acceptance. On the other hand, Shafi

˘

is and Hanbalis ruled thatbuyer and seller retain the option to rescind the sales contract as long as they havenot parted from the contract session. This is called the “contract session option”

66 Sale-Based Islamic Finance

(khiyar al-majlis), which is based on an authentic Prophetic tradition: “The twoparties to a sale have the option [to rescind it] as long as they have not parted, andone of them may give the other the option for a longer period.”2

A number of restrictions on objects of sale were put in place, in part to ensurethat sales contracts are not used as ruses for riba, and in part to protect the interestsof contracting parties. With the exception of prepaid forward sales (salam) andcommissions to manufacture (istisna

˘

), to be discussed separately in later chapters,objects of sale must exist at the time of the contract. Moreover, for a sale tobe executed, objects of sale must be owned by the seller, in his possession, anddeliverable to the buyer. This set of conditions is central to the practice of Islamicfinancial institutions, wherein the financial institution must own a property inorder later to sell or lease it to its customer. As noted above, this requirementresults in additional legal costs for the extra sale and establishment of SPVs, aswell as potential additional sales taxes, licensing fees, and the like. Interestingly,although the Shafi

˘

is and Hanbalis listed the seller’s ownership of an object of saleas a condition of conclusion of the sale contract, Hanafis and Malikis deemed itonly a condition of execution of the sale. Thus, the latter two groups of scholarsdeemed sales by an “uncommissioned agent” (known in Arabic as bay

˘

al-fuduli)concluded but suspended pending the [ultimate] seller’s approval.3

The Underused Uncommissioned Agent (Bay‘ al-Fuduli) Structure

In this regard, while most areas of Islamic finance tend to be dominated by theHanafi and Hanbali schools of jurisprudence,4 there is ample evidence that opin-ions from other schools of jurisprudence have been accepted in the industry. Forinstance, in the classical murabaha practice, wherein the bank buys a propertyand then sells it on credit to customer, jurists and banks have accepted a Malikiopinion of the jurist Ibn Shubruma – to allow the bank first to obtain a bind-ing promise by its customer that he will buy the property after the bank buys it.It appears that developments along the “uncommissioned agent” opinions of theHanafis and Malikis can greatly reduce the transaction costs in murabaha financ-ing, by approximating conventional procedures more accurately.

Thus, the bank may act as an uncommissioned agent for the seller, selling hisproperty to the customer on credit. At this stage the customer will owe the sellerthat property’s price plus mark-up as determined by market interest rates, if theseller were to accept it. The seller may accept to provide financing to the customerdirectly, in which case the bank would be entitled only to its agency commission.On the other hand, if the seller demands receiving the price in cash, the bank – asagent – may conclude the sale by paying him the cash price he demanded, whilecollecting from the customer the credit price he agreed to pay. Thus, the bank


would act as a traditional financial intermediary, with the associated lower costs,rather than trading in property.

Although this alternative structure based on uncommissioned agent trading(bay

˘

al-fuduli) may not necessarily be acceptable to all jurists, it appears to havebeen used in Islamic finance in the GCC. For instance, fatwa #62 for Dalla Al-Baraka and fatawa #17 and #24 for Kuwait Finance House all permitted theuncommissioned agent structure, arguing that ex post acceptance of the Islamicbank (that the customer bought on its behalf ) is equivalent to ex ante agencyauthorization.5

Trust Sales: Murabaha, Tawliya, Wad. i‘a

The most common type of sale in Islamic jurisprudence is negotiated-price salebay

˘

al-musawama), wherein the two parties agree on a price at which they areboth willing to conclude the transaction. However, there are three other types ofsale, wherein the two parties agree on a profit or loss margin, and the buyer relieson the seller’s truthful revelation of his cost. In murabaha the two parties agree totrade at a price equal to the cost plus mark-up or profit, in tawliya they trade atcost, and in wad. i

˘a they agree to trade at a marked-down price.6

In murabaha and tawliya, jurists ruled that the seller must be the owner, oth-erwise it is impossible for the seller to disclose the cost at which he obtained theproperty. The most common method of financing by Islamic financial institu-tions is “murabaha to order.” It is based on a concatenation of two opinions, oneby Al-Shafi

˘

i that permitted a potential buyer to tell a seller “buy this property,and I will buy it from you at x percent mark-up,” and an opinion of the Malikijurist Ibn Shubruma that allows the potential buyer’s promise to be made binding.In the first conference of Islamic banks in Dubai (1979), participants concludedthat “this type of promise is legally binding on both parties based on the Malikiruling, and religiously binding on both parties for all other schools.” This rul-ing was reiterated in 1983, at the second conference of Islamic banks in Kuwait,reasoning that “this [murabaha] sale is valid as long as the bank is exposed to therisk of destruction of the good prior to delivering it to the buyer, as well as theobligation to accept return of the good if a concealed defect is found therein.”

Led by the Pakistani jurist and retired Justice M. Taqi Usmani, jurists whoare involved in Islamic finance have allowed the rate of return in murabaha tobe benchmarked to conventional interest rates. In this regard, the rate of returnearned by the bank was justified by two risks: (1) the risk of ownership betweenthe two sales, and (2) the risk that the property may be returned to the bank (asseller) if a defect is found therein. We must note, however, that the risk of own-ership can be made minimal by restricting the time period between the two sales


to minutes, if not seconds. Moreover, although jurists insist that any cost of in-surance of the property during that period must be borne by the Islamic financialinstitution, the bank may negotiate a mark-up that compensates it for that cost.Similarly, the cost of insuring against the risk of having to accept the return of de-fective merchandise can be transferred easily back to the original seller or forwardto the buyer. Thus, the only material risks to which the bank is exposed are creditrisk and interest rate risk, which conventional banks specialize in managing. In-deed, many of the transaction costs associated with Islamic finance arise preciselyfor the purpose of eliminating all other (e.g., commercial) risks, which banks arenot particularly well equipped to manage.

Currency Exchange (Sarf)

The well-known Prophetic tradition on riba, discussed in Chapter 3, listed sixcommodities that should be traded hand-to-hand and in equal quantities. In avariation on this Prophetic tradition that applied exclusively to monetary com-modities,

˘

Umar ibn Al-Khattab said, “Do not sell gold for gold or silver for silverexcept in equal quantities. Moreover, do not trade gold for silver with one ofthem deferred. Even if your trading partner asks you to wait until he can fetchthe money from his house, do not accept the deferment. I fear that you will fallin riba.”7 Thus, murabaha financing cannot be applied to trading gold for silverwith deferment for equal or different quantities.

Of course, gold and silver represented the bimetallic monies of the time, andthus trading gold for gold, silver for silver, or gold for silver were all grouped to-gether under the title “currency exchange,” or sarf. In those trades the aforemen-tioned Prophetic tradition requires the exchange to be hand-to-hand (i.e., withoutdeferment), and if the two compensations are of the same genus, then they mustbe equal in weight. No conditions or options are allowed in this contract, whichis deemed binding at its conclusion.

The earliest jurists reasoned by analogy that currency exchange contracts maynot be used to settle existing debts (e.g., settling a debt for gold with payment insilver). However, later jurists reasoned by juristic approbation that clearing a debtin one currency with payment in another currency is permissible if both partiesconsent to it, regardless of when and how the debt was initiated, and in somecases, the exchange would be enforced without need for mutual consent.8

Contemporary jurists have allowed regular currency-trading transactions, inwhich a payment in one currency is made in one country, and receipt of anothercurrency is made in a different country, possibly at a later time. This practice wascharacterized as an instantaneous currency exchange contract in the first coun-try, followed by an interest-free loan to be repaid at the later date in the other


country.9 Of course, the underlying assumption is that exchange will be carriedout at the spot exchange rate of the initiation date, to avoid suspicion of riba.On the other hand, those familiar with the evolution of modern banking in Eu-rope will recognize bills of exchange along those lines (known by the Arabic namesuftaja) as the classical forms through which Medici bankers managed to embedinterest rates in exchange rates, to circumvent the classical Catholic prohibition of“usury.”10

Metals and Tawarruq

Another interesting development in Islamic finance is that some precious metals(e.g., platinum) were exempted from rules of currency exchange. For instance, theRajhi Investment Company’s Shari

˘

a board reasoned as follows in its fatwa #101:

Platinum is a precious metal that does not inherit the legal status rulings of gold and silver,even though some people call it “the white gold.” Thus, mutual receipt during contractsession is not required for platinum, and it may be sold with deferment in exchange forcurrency.

In general, platinum is subject to legal status rulings for metals other than gold and sil-ver. Thus, if the company [Al-Rajhi] wishes to deal in this metal when it is not present [inthe seller’s possession], it may only buy it through salam [prepaid forward contract], subjectto all the conditions of that contract. Moreover, the company must receive the metal priorto reselling it.11

Thus, although the classical rules of currency exchange very strictly ensuredthat an interest-bearing loan cannot be manufactured out of trade, recent devel-opments in jurisprudence have allowed trade-based financing to replicate loans.This is especially prevalent today through the tawarruq contract that is increas-ingly practiced in GCC countries. Thus, if a customer wishes to borrow $10,000and pay 5 percent interest, and the bank wishes to lend him the money at thatrate, the bank needs only to buy $10,000 worth of platinum from a dealer, sell tothe customer on a credit basis for $10,500 to be paid later, and then sell the plat-inum on behalf of the customer back to the dealer, thus generating the desiredresult. Needless to say, all interest-based financial transactions (including loansand bonds) can be (and are in fact) generated through such trade cycles, whichinvolve a credit component through either credit sales or prepaid forward sales.

In the context of tawarruq as practiced by Islamic banks, it is noteworthy thatmost classical jurists deemed it impermissible for one entity to execute a sale asagent for both trading parties, with the exceptions of judges, plenipotentiaries,and parents.12 This restriction was intended to ensure that sales contracts arelegitimate, and that they are perceived by all parties to be beneficial to them. Oneparticularly troublesome practice that would be voided by this restriction applies


to banks engaging in “trade” for the purpose of tawarruq financing, whereby thebank acts as an agent for its customer and the merchant – buying commoditiesfrom the merchant, selling to the customer on credit, and then selling back to themerchant for the amount of cash desired by the customer.

4.2 Same-Item Sale-Repurchase (‘Ina)

Most recent developments in Islamic finance involve the utilization of a commod-ity or property as one degree of separation to recharacterize an interest-bearingloan in the form of trade. Thus, we have just described the most common formof tawarruq financing that has become increasingly popular in Saudi Arabia, UAE,and other GCC countries in recent years. This practice was common in earlierdecades for larger corporate customers of Islamic banks and financial institutions.For those larger customers, the bank did not need to provide agency services forall sales. Indeed, larger customers were capable of borrowing through a simplemurabaha transaction for platinum, and they had the necessary recourses to sellthe platinum on the spot market to obtain desired liquidity. This was particu-larly advantageous to bankers who operated in countries wherein tawarruq wasunacceptable, whereas murabaha was.

As noted briefly in previous chapters, most Islamic bond (sukuk) structuresdeveloped in recent years also involve the sale and repurchase of some propertyor commodity. Thus, short-term bill-like instruments are manufactured throughprepayment (salam) sale of commodities, and long-term bondlike instrumentsare manufactured through sale of a property, followed by leasing back the sameproperty, and possibly buying it back at lease end. In this section we shall reviewclassical and contemporary juristic rulings on same-property sale-repurchase andtheir implications for Islamic finance.

Same-Item Trading in ‘Ina and Tawarruq

The classical bay

˘

al-

˘

ina (same-item sale-repurchase to circumvent the prohibi-tion of interest-based lending) was discussed extensively in the classical juristicliterature.13 Discussion centered mostly around Prophetic traditions, the authen-ticity of which were accepted by some jurists but not others. In the simplest formof

˘

ina sale to produce interest-based debt, the “borrower” sells some propertyto the “lender” and receives its cash price. Then, the “lender” turns back andsells the same property to the “borrower” on credit, at a higher price equal tothe “principal,” or cash price, plus interest. Classical jurists also recognized thata third party may be introduced as an intermediary, whereby A (dealer) sells toB (bank) in cash, B sells to C (customer/borrower) on credit, and C sells to A

4.2 Same-Item Sale-Repurchase (‘Ina) 71

in cash. Of course, if jurists were to forbid same-item repurchase through oneintermediary, more degrees of separation – for example, trading parties D and E– may be added.

Abu Hanifa had generally ruled that the validity of sales is determined by con-tract language. However, he ruled that same-item sale-repurchase without anintermediary third party is defective, based on a tradition of Zayd ibn Arqam.14

He also reasoned that if someone sells a property on credit, and then the buyersells it back to him for cash, the second sale would not be valid. He based thatruling on the view that the deferred price in the first sale would not have beenreceived, and thus the second sale (which is contingent on the first) could not bedefinitively concluded. Of course, the latter objection can be circumvented for-mally in Islamic banking by asking the customer first to sell any property to thebank for cash, and then turn around and buy it back on credit.

The two closest associates of Abu Hanifa differed in opinion regarding thiscontract. Thus, the judge Abu Yusuf ruled that the contract is valid and not rep-rehensible, whereas Muhammad Al-Shaybani found it extremely reprehensible, asan obvious stratagem invented to circumvent the prohibition of riba. Similarly,Shafi

˘

i and Zahiri jurists ruled that the contract is valid, since it satisfies the cor-nerstones and language of valid sales, and since Al-Shafi

˘

i himself did not acceptthe tradition of Zayd as authentic. However, they reasoned, it is reprehensiblesince the intent to legitimize riba through sales is clear, although their legal theorydid not allow them to invalidate a contract based on such analysis of intent.15

Interestingly, Maliki and Hanbali jurists ruled that same-item sale-repurchasewithout a third-party intermediary is forbidden, by invoking the rule of prevent-ing means of legitimizing illegitimate ends (sadd al-dhara

˘i

˘

). However, if a third-party intermediary is present (as in the case of tawarruq), most Malikis and someHanbalis reasoned that the contract is merely reprehensible. Since the use oftawarruq has been spreading quite rapidly in the GCC region (especially SaudiArabia and UAE) based on its permissibility among some Hanbali jurists, it seemsappropriate to review some of the more recent classical and contemporary juristicopinions regarding this contract.

Hanbali Denunciation of Organized Tawarruq

Ibn Qayyim Al-Jawziyya, a prominent Hanbali jurist and star student of IbnTaymiyya, said the following regarding Ibn Taymiyya’s attitude toward tawarruq:

and our teacher (God bless his soul) forbade tawarruq. He was challenged on that opinionrepeatedly in my presence, but never licensed it [even under special circumstances]. Hesaid: “The precise economic substance for which riba was forbidden is present in thiscontract, and transaction costs are increased through purchase and sale at a loss of somecommodity. Shari

˘

a would not forbid a smaller harm and permit a greater one!”16


Similarly, Al-Ba

˘

li reported in his selection of juristic rulings of Ibn Taymiyyathat the latter had forbidden tawarruq.17 More recently, two very prominentjuristic councils, both housed in Saudi Arabia, tackled the issue of tawarruq. Themore prominent Fiqh Academy of the Organization of Islamic Conference, inJeddah, Saudi Arabia, forbade tawarruq. The second and generally less prestigiousFiqh Academy of the Muslim World League, in Makka, Saudi Arabia, issued tworulings on the transaction. The first opinion was issued in the fifteenth session ofthe academy in October 1998. It permitted the contract subject to the conditionthat the customer does not sell the commodity to its original seller, to avoid directevidence of

˘

ina as a legal stratagem to circumvent the prohibition of riba. Inthe seventeenth session of the academy, held in December 2003, they tackled theissue of “tawarruq as practiced by Islamic banks today” and forbade it. They basedtheir decision on the following characterization and reasoning:

After listening to presented papers on the subject, and discussions thereof, the Academyrecognizes that some banks practice tawarruq in the following manner:

The bank routinely sells a commodity (other than gold or silver) in global markets orotherwise to the customer on credit, wherein the bank is bound – by virtue of a contractcondition or convention – to sell the commodity to another buyer for cash, which the bankdelivers to the customer.

After study and deliberation, the Academy ruled as follows:

First, tawarruq as described above is not permissible for the following reasons:

1. The seller’s obligation to act as the buyer’s agent to sell the commodity to anotherbuyer, or making similar arrangements, makes the dealing akin to the forbidden˘

ina, whether that obligation is spelled out as an explicit contract condition, ordetermined by custom.

2. In many cases, this type of transaction would result in nonsatisfaction of receiptconditions that are required for validity of the dealing.

3. The reality of this transaction is extension of monetary financing to the party char-acterized as a tawarruq customer, and the buying and selling operations of the bankare most often just meant for appearances, but in reality aim to provide the bankan increase in compensation for the financing it provided.

Some banks have attempted to address those concerns of the Muslim WorldLeague Fiqh Academy by ensuring that all trasanctions are bona fide sales andpurchases, with corresponding transfer of commodity risks. Towards that end,many banks in Saudi Arabia have begun to emphasize that all commodities usedfor tawarruq are bought and sold in domestic markets, with real merchants de-livering the goods or reassigning their ownership as dictated by trade. However,it would appear that this increased emphasis on forms misses the argument madeby Ibn Taymiyya as reported by Ibn Qayyim: that the difference between what is

4.2 Same-Item Sale-Repurchase (‘Ina) 73

permitted and what is forbidden cannot possibly be determined by the amount oftransaction costs involved (with higher transaction costs favored!).

Returning to our analysis of riba in Chapter 3, it appears that the true demar-cation should be determined by “marking to market.” We explained the canonicalprohibition of trading dates for dates in different quantities by arguing that whendates are sold for money, one seeks the highest bid, and when one uses the moneyto buy dates, one seeks the lowest offer. This enhances efficiency in markets (es-pecially if added transaction costs are negligible) and ensures equity in exchange.Similarly, if financing is replaced by bona fide trade, as both Fiqh Academies haveagreed, then the financing charge in murabaha financing (whether or not the cus-tomer plans to sell the commodity for cash) will be determined by the differencebetween actual cash and credit prices in the marketplace.

In contrast, a tawarruq transaction is usually structured by banks to equate fi-nancing charges to market interest rates on loans to similar borrowers, regardlessof the actual underlying commodity. It is thus possible to understand the FiqhAcademies’ opinions in terms of rejection of robbing the trading componentsof Islamic finance of all economic significance, thus squandering the potentialefficiency-enhancing provisions built into Islamic jurisprudence. The distinctionbased on marking to market is more significant in Islamic transactions structuredthrough leases, where a market lease rate may be computable and useful for com-parison to the interest rate being charged on similar financial products.

Custody Sale (Bay‘ Al-‘uhda) and Sukuk Al-ijara

We have described the recent lease-backed Islamic bonds briefly in the introduc-tion, and we shall discuss them in much greater detail in Chapter 6. The structurequite simply proceeds as follows. The entity that desires to issue bonds (be it asovereign government, a corporation, etc.) creates an SPV that sells certificates(sukuk) for the amount of the bond issuance. The SPV uses the proceeds to buysome property (typically, land, buildings, machines, etc.) from the issuer andproceeds to lease the property back to the seller. The issuer pays rent, which ispassed through the SPV to certificate holders. At lease end, the issuer typicallybuys the property back from the SPV (although in at least one structure that weshall discuss in detail, the property will be given back as a gift from the SPV tooriginal seller).

We have noted in Chapter 1 that there are two elements of same-item sale-repurchase in this structure: (1) the property and its usufruct are sold to the SPV,and then the usufruct is purchased back through the lease, and (2) the propertyitself (and all of its remaining usufruct) is purchased back at lease end. Thisraises the issue of

˘

ina, which would deem the contract forbidden. However,


same-item sale-repurchase has been approved in lieu of debt by some schools ofjurisprudence. That sale form is called fulfillment sale (bay

˘

al-wafa˘

), wherein aproperty is sold on condition that once the seller returns the price, the buyer mustreturn the property. Shafi

˘

i jurists call this trade bay

˘

al-

˘

uhda (custody sale), andthe Hanbalis call it bay

˘

al-amana (trust or faithfulness sale).Maliki and Hanbali jurists, as well as early Hanafi and Shafi

˘

i jurists, ruledthat such sales are defective, since they were viewed as legal stratagems to reachillegitimate ends (forbidden riba) through legitimate sale means. In this regard,they forbade the practice by characterizing the apparent sale as a loan of the price,with usufruct of the property being the profit or interest collected on the loan.Interestingly, this ruling is reinforced in sukuk structures, wherein the usufruct isfurther monetized through leasing the property back to the seller. However, somelater jurists have allowed the contract based on convention, thus paving the roadfor its contemporary utilization.18

In general, Islamic jurisprudence does not forbid the same property being soldback to its original seller, provided that the two sales are not stipulated in theoriginal contract. Otherwise, a sales contract that requires the buyer to sell theproperty back is not a sale at all, since the buyer never in fact obtains ownershiprights, which include the right not to sell the property, and certainly the rightnot to sell it to any given individual or entity (e.g., the original seller). However,the precedent of fulfillment sale mentioned in this section opened the door forthe possibility of constructing the sukuk structures that have become popular inrecent years, which we discuss in Chapter 6.

Now, we may return once more to the issue of “marking to market,” whichwe argued to be at the heart of the prohibition of riba. Many Islamic financepractitioners have hailed the ability of countries and corporations to engage insecured lending through sale-lease-back-repurchase certificates, which may – intheory, if not in practice – allow them to borrow at lower rates. Indeed, becauseof the recent preponderance of those issuances, Standard and Poor’s has developeda rating methodology for such lease-backed bonds (discussed in Chapter 6), andthe country of Bahrain has progressively used that tool to refinance substantialamounts of its conventional debt at lower interest rates. Invariably, however, theinterest rates on those secured bonds are benchmarked to interest rates for con-ventional bonds with similar credit ratings. We must thus turn to this issue ofbenchmarking Islamic financing rates to conventional interest rates.

4.3 Cost of Funds: Interest-Rate Benchmarks

Contemporary jurists have simultaneously lamented benchmarking implicit in-terest rates in Islamic sale- and lease-based financing to conventional interest rates

4.3 Cost of Funds: Interest-Rate Benchmarks 75

(such as the London Interbank Offer Rate [LIBOR]) and argued that such bench-marking by itself would not deem the financing un-Islamic. A favorite argumentof contemporary jurists’ has been drawing an analogy to two lines of business,one legitimate and the other illegitimate. Just the fact that the legitimate business(say, a carpenter’s shop) may demand the same profit rate as the illegitimate one(say, a brewery, which earns a 6 percent profit rate), they argued, does not ren-der the legitimate business illegitimate. Other analogies that one hears at Islamicconferences compare the price of halal chicken (chicken slaughtered accordingto Islamic standards) to the prices of chicken processed otherwise, again arguingthat numerical equality of prices does not imply similar legal status of the pricedproperties.

Needless to say, those analogies are patently fallacious: The object of sale inIslamic finance does not differ from the object of sale in conventional financethe way carpentry differs from brewing, or even the way halal or kosher chickendiffer from regularly slaughtered chicken. When an Islamic financial providerstructures an “alternative” to conventional finance (say, a conventional mortgage)through double-sale murabaha financing facility, the ingredients of the financialtransaction are the same as those for conventional mortgage (cost of funds, creditrisk, collateral property risk, etc.), and the output is the same (a debt on thecustomer equal to the sum of money he needed to purchase the property plusfinance charges exceeding the bank’s cost of funds).

In this regard, whether a double-sale procedure is followed, or a simpler singlesale takes place via an uncommissioned agent (bay

˘

al-fuduli), as suggested earlierin the chapter, the financial provider still converts funds now into funds in thefuture and compares his future cost of funds (the interest rate he has to pay tofund providers, whether they are depositors, sukuk holders, etc.) to the rate ofreturn that he collects. It is in this spirit that we have argued that the “murabaha”disclosure rules – when applied to finance – dictate that the Islamic financiershould report his cost of funds and interest-rate mark-up to its customers.

Opportunity Cost for Conventional Fund Providers

It is not surprising that LIBOR is the benchmark of choice for Islamic bankers andfinanciers. That interbank rate represents the opportunity cost for bankers whoare operating or were trained in the United Kingdom, as most Islamic bankershave been. If the bank is left with idle funds, LIBOR represents the rate of re-turn it can obtain by lending those funds to other banks. Hence, other borrow-ers/finance customers must pay the bank a rate of return equal to LIBOR plus amark-up commensurate with the level of credit risk to which the bank is exposedby lending to them, rather than lending to other banks. Thus, LIBOR has been


the appropriate benchmark for London bankers to use, and the historical prece-dent for the majority of Islamic bankers who started their careers in U.K.-basedconventional banking.

In contrast, the Islamic financial customer has no access to funds at LIBOR,and any familiarity he may have with interbank rates would merely result from hiseducation and level of familiarity with various financial publications. Bankers willnaturally demand at least LIBOR plus the appropriate spread, and competitionwill naturally drive implicit interest rates on Islamic financing closer to that bench-mark rate (as Shari

˘

a-arbitrage rents vanish). However, bankers do their customersa disservice by limiting the process of Islamic financing to explicit benchmarkingof interest rates to LIBOR or any other market rate, and implicitly to rates thatcompetitors would charge (as dictated by truth-in-lending provisions in variousWestern countries).

Indeed, the customer should also consider his own opportunity cost to involve-ment in a financing contract with any particular financial services provider. Inthis regard, the asset-based nature of Islamic finance, if taken seriously, can pro-vide the customer with another economic comparison to determine whether ornot he should engage in any particular financial transaction. Within the contextof our mortgage example, an appropriate Islamic model (whether it is a buy-sell-back murabaha transaction, or a buy-lease-back ijara transaction, etc.) should domore than merely camouflage a conventional mortgage loan through sales, leases,and the like. It should provide the customer with appropriate tools for determin-ing whether or not the purchase of a particular property at a particular price andfinancing that purchase at a particular interest rate constitute a good investmentor financial decision. Islamic financial providers should be equally interested inlooking beyond the quality of collateral and borrower in terms of the credit riskassociated with an Islamized mortgage loan.

This may be done by disentangling the benefits from owning a property andbenchmarking each component to the appropriate market variable. Thus, capitalgains on the property (at the appropriate level of leverage) should be comparedto capital gains that could be made on other investments. Rental rates (value ofusufruct) of similar properties should be compared to interest paid on the bor-rowed sum, after factoring in tax advantages of deducting mortgage interest forincome tax purposes, where applicable.

Financially wise customers make such comparisons in conventional as well asIslamic financial transactions. One difference between conventional bankers andIslamic bankers should be increased involvement of the banker in the real transac-tion being undertaken by the customer, even if – in the end – it is only a financialtransaction for the bank, which should be benchmarked to the bank’s opportunitycost as measured by LIBOR or other interest rates. An Islamic banker would thus


use additional benchmarks (which every customer should use, but often manywould not without the help of a financial advisor) to decide whether or not thefinancial transaction is advantageous to the customer.

The explicit mechanics of a real transaction (the bank having actually to get in-volved in buying and selling the property, or leasing it, etc., even if at arm’s lengththrough special purpose vehicles, or ex post through uncommissioned agency)force Islamic financial providers to take their customers through this cold un-emotional financial calculus. Although efficiency would dictate performing thosecalculations only within the context of counterfactual financial scenarios (thusavoiding unnecessary transaction costs), the sad reality is that Islamic finance inthe short-to-medium term will likely remain captive to premodern procedures,where the actual trading, leasing, and the like is required. The use of additionalbenchmarks, as discussed in this section, would – at least – allow the spirit ofIslamic jurisprudence to be served through adherence to those premodern formsas adopted by Islamic financial providers.

Viability of Islamic Benchmark Alternatives

In recent years a number of jurists and Islamic bankers have called for the de-velopment of “Islamic benchmarks,” while maintaining that benchmarking ratesof return in sale- and lease-based Islamic financing to conventional interest ratesis legitimate. The reason suggested by those Islamic finance practitioners is thatmurabaha financing with a profit rate benchmarked to market interest rates lookssuspiciously similar to a conventional loan. Those proponents of an Islamicbenchmark have also expressed the ambitious goal of eventually developing anentire Islamic yield curve, to be used for benchmarking rates of return in Islamicfinance facilities of varying maturities. The recent growth in Islamic bonds (sukuk)issues was thus hailed as a positive step in the direction of developing that Islamicyield curve, which presumably can easily emerge once that market develops suffi-cient depth and liquidity.

In fact, however, this search for Islamic benchmarks and yield curves is mis-guided, for a number of good reasons. First, Islamic financial practitioners’ dis-comfort with benchmarking to conventional interest rates seems to be based oncontinuing misconceptions such as that Islamic finance is “interest free” or that Is-lamic jurisprudence does not recognize the time value of money. As we have seenin Chapter 3, those views – which were foundational for the Islamic economicsliterature that predated Islamic finance – are fundamentally flawed. Indeed, Is-lamic jurisprudence does recognize the time value of money, which is preciselywhy a seller may charge a higher price for a credit sale than he would for a cashsale of the same property.


In this regard, one must note that the juristic argument that “time value isrecognized in sales but not in debts or loans” is at best insufficient, and at worstdisingenuous. If the claim is based on the need for pricing time value for eachtransaction separately (based on credit rating, quality of collateral, etc.), thenthere is a valid argument to be made (in conventional as well as Islamic finance).However, the mere claim is insufficient in this case, since the manner in whichappropriate interest rates are determined in sales, leases, and the like remains un-specified. On the other hand, if interest rates in Islamic finance (including thepure time-value components thereof ) are benchmarked to conventional interestrates, it would appear that the general claim is vacuous and disingenuous, sinceit serves only to create arbitrage opportunities, from which jurists stand to beprimary beneficiaries.

Divergence of Rhetoric from Reality

With regard to “interest rate” (or the equivalent Arabic “si

˘

r al-fa˘

ida”), we haveto recognize that although the term may have initially applied only to interest onloans, modern usage applies it to any compensation for time value. In fact, anIslamic financial provider in the United States is required by “truth-in-lending”regulation Z to report the implicit “interest rate” in lease or double-sale financ-ing. The sooner Islamic finance providers can disabuse their customers of thoselingering misconceptions about time value and permissibility of charging interestin certain types of transactions, the higher will be the industry’s credibility withregulators and customers alike.

A closely related reason why Islamic finance practitioners feel uncomfortableabout using conventional interest rates as benchmarks is the Shari

˘

a arbitrage na-ture of Islamic finance, as illustrated in Chapter 1. In fact, Islamic finance hasbeen, and continues to be, fully dependent on conventional finance for its ex-istence and the nature of its products, as well as its rates of return. If Islamicfinancial providers continue to market their industry based on the rhetoric thatconventional finance is generally forbidden and exploitative, then benchmarkingto conventional interest rates will continue to be an embarrassment, promptingskeptical customers to ask: “What is the difference between Islamic and conven-tional finance?” In contrast, if Islamic financial providers were to focus on thesubstance of Islamic jurisprudence instead of its forms, they can explain to cus-tomers that some – but not all – forms of debt are harmful, and some – but notall – forms of interest are harmful.

Indeed, industry rhetoric needs to change so that a double-sale (tawarruq style)at 100 percent interest is recognized as usurious predatory lending rather thanlegitimate trading. Islamic financial providers need to explain to customers thatthe purpose of following nominate forms of classical Islamic jurisprudence is to


impose discipline and ensure that we select from the wide range of conventionalfinancial products only the ones that are advantageous to particular individualsbased on their specific circumstances. Then the fact that credit selected throughthat methodology costs the same as credit selected through different (conven-tional) screens would no longer be a source of concern or embarrassment for theindustry.

Finally, one of the potential advantages of asset-based Islamic financing is thatit can be provided at rates that deviate substantially from a time-value benchmarkplus credit-risk premium. For instance, a country or corporation with a poorcredit rating may be able to obtain financing at implicit interest rates substantiallybelow those dictated by its credit rating if it genuinely collateralizes its debt withreal assets, for example, through the currently popular sale-lease-back sukuk struc-tures. At least theoretically, lease-backed sukuk with different underlying assetsshould have different implicit interest rates, depending on the quality of collat-eral, its depreciation rates, market rent, and the like. Moreover, as we shall arguein Chapter 10, lease sukuk built on bona fide sale of government assets can helpin restarting stalled privatization programs in various Islamic countries.

Disadvantages of “Islamic Benchmarks”

It is true that if implicit rates in Islamic finance were indeed to vary accordingto the qualities of underlying assets, then the “Islamic-debt” market would neverdevelop sufficient depth and liquidity to generate a uniform benchmark that canbe used to determine implicit rates for other Islamic financial transactions. Onthe other hand, if – as has indeed been the case – the issued sukuk are backedby the full faith and credit of issuing governments and corporations, and thusresulting implicit interest rates are determined solely by the issuing entity’s creditrating and a conventional benchmark (typically LIBOR), then referring later tothose implicit interest rates is at best cosmetic, and at worst misleading. It wouldbe cosmetic if we first strip the implicit interest rate of its credit-risk premium,essentially to reproduce LIBOR under another name, prior to adding the appro-priate credit-risk premium for another Islamic debt instrument. To the extent thatreproduction of the underlying measure of time value may be erroneous, bench-marking to such rates may lead to erroneous pricing of other Islamic financialinstruments.

Consequently, the development of an “Islamic benchmark” is (1) unnecessary,since there is no reason to be embarrassed about using conventional benchmarks,(2) impractical, since sufficient depth and liquidity of homogeneous Islamic fi-nancial assets is unlikely, and (3) superfluous or dangerous, since the only logicalor practical approach to developing such an Islamic benchmark would be to try torecover the underlying conventional benchmark, which may be done erroneously.


It would be more advantageous for industry practitioners to explain to customersthat the products they offer must meet all conventional product requirements,in addition to Islamic considerations that essentially provide further protection tothose customers. Then, if Islamic financial products are more expensive than theirconventional counterparts (which they are, almost always), bankers can explainthat this additional cost is compensation for the service being provided throughadherence to those prudential requirements of Islamic jurisprudence, in analogyto higher fees charged by full-service brokers who provide investment advice totheir customers.

Other Conventional Benchmarks

While we are discussing the subject of interest-rate benchmarks, it is worthwhilenoting that the use of LIBOR as a benchmark, while reasonable for many bank-type financial instruments, seems less appropriate for sovereign bonds. Bench-marking to LIBOR reflects the industry’s dependence on London-based banks,and domination – even after the industry’s centers of gravity moved from London,Geneva, and Luxembourg to Kuala Lumpur, Bahrain, and Dubai – by bankerswho are based, or used to be based, in London. In this regard, no reasonable per-son would disagree that LIBOR is perhaps the best measure of an English bank’sopportunity cost of funds, and hence benchmarking to that rate makes perfectsense for Islamic financial instruments that are similar to bank loans.

In contrast, many of the countries that continue to issue “Islamic debt” (mainlyBahrain, Qatar, Malaysia, Pakistan, and others likely to join the sovereign sukukmovement in part to retire their conventional debt, as in the case of Bahrain),would like to be viewed as “emerging markets.” Indeed, Malaysia and Turkey –which is currently contemplating issuing sukuk – have been on the radar screensof emerging market debt traders for a number of years. In that market the bench-mark most commonly used is the yield on U.S. Treasury bonds – with emergingmarket bond yield spreads (e.g., on indices such as JP Morgan’s EMBI+) overU.S. Treasury yields now serving as the most common measures of global eco-nomic risk. Migrating sovereign sukuk benchmarking from LIBOR to Treasuryyields would be a sign of maturity in the sector, signaling graduation of thosesukuk from a market-niche curiosity generated by bankers and lawyers.

5

Derivative-Like Sales: Salam, Istisna‘, and ‘Urbun

As we indicated in the previous chapter, existence of some property as the object ofsale is generally a condition for contract validity. However, there are two notableexceptions that allow sales of nonexistent objects. The first is an ancient contractthat predates Islam, called salam in the Hijaz area of western Arabia, wherein theProphet lived, and salaf in Iraq, both terms meaning “prepayment.” This con-tract was primarily used for financing agricultural production and was legalized bythe Prophetic traditions cited below. A similar contract, called istisna

˘

, meaning“commission to manufacture,” was legalized in later centuries, likewise to assistfinancing of nonagricultural (e.g., manufacturing) production.

In recent years Islamic financial practitioners have adapted the classical forms ofsalam and istisna

˘

and combined them with other transactions to generate approx-imations of conventional financial transactions, including interest-bearing loans,interest-bearing bills and bonds, build-operate-transfer and build-operate-own in-frastructure and other project financing, etc. We start this chapter by reviewingthe classical rules on salam and istisna

˘

and the innovative uses of those contractsthat have been approved in recent years (not entirely without controversy) by var-ious juristic bodies.

5 .1 Prepaid Forward Sale (Salam)

All six major compilers of Prophetic tradition narrated on the authority of Ibn˘

Abbas that when the Prophet migrated to Madina (formerly known as the cityof Yathrib), he found its inhabitants engaging in one-to-three-year forward salesof fruits, with prices being prepaid at contract inception (which gives salam =“prepayment sale” its name). He then narrated that the Prophet said, “Whosoeverengages in a salam contract, let him specify a volume or weight for the object ofsale, and a definitive term of deferment.” Thus, jurists of all schools considered theforward sale of fungible commodities (measured by weight, volume, length/size,

81

82 Derivative-Like Sales: Salam, Istisna‘, and ‘Urbun

or number of homogeneous units), with full prepayment of the price, to be avalid contract. As in all forward and futures contracts, jurists stipulated that theobject of sale should be specified in genus, type, and quality, as well as quantity,however measured. In this regard, they agreed that the salam contract constitutedan exception to the general prohibition of sale of nonexistent properties, as wellas the prohibition of sale of properties that are not in the seller’s possession at thetime of sale.1

Classical jurists recognized the economic need for this contract primarily toallow farmers access to capital (price of salam), with which they can buy seeds,fertilizer, and other materials to grow their crops. However, they also recognizedthat the contract includes an element of speculation, since the salam seller benefitsif the spot price at delivery time is lower, and the buyer benefits if it is higher.They also recognized that salam includes price discounting for time, that is, anelement of interest, since the prepaid salam price will be generally lower than theexpected spot price at time of delivery. This recognition prompted classical juriststo stipulate numerous conditions on salam contracts, to minimize elements ofgharar and eliminate elements of riba therein.

In their efforts to avoid the abuse of salam contracts to synthesize riba-liketransactions, classical jurists imposed strict conditions on delivery and settlementoptions for the salam-short (seller).2 On the other hand, it is clear – as we shall ar-gue later – that conditions on immediate or near-immediate delivery of the price,which distinguish salam contracts from contemporary forwards, are rendered im-material if the salam-long can simultaneously obtain a credit line (e.g., throughtawarruq or murabaha) for the present value of the desired forward price. Hence,we shall focus on the delivery restrictions, which are generally observed today andwhich have given rise to legal stratagems such as parallel salam.

Revocation and Settlement of Long Position

If the salam-long wishes to take part in a salam contract for purely financial pur-poses, without intent of taking delivery of the salam object, he can theoreticallyattempt to achieve his goal in one of two simple ways: (1) settle the positionwith the salam-short in cash or some other commodity (based on spot prices onthe delivery date, or some other formula), or (2) sell the salam-long position toa third party, which is tantamount to selling the salam object prior to receivingit. In their efforts to restrict salam contracts to genuinely needed economic activ-ities, such as the original financing of agricultural production, premodern juristsgenerally forbade both avenues. However, as we shall see in the next two sections,contemporary jurists have utilized some minority opinions, as well as the permis-sibility of debt transfers for salam objects, to synthesize purely monetary financialtransactions from the salam contract.

5 .1 Prepaid Forward Sale (Salam) 83

A third way to settle a salam financially would be to revoke the contract shortlybefore delivery, whereby the salam-long may accept a different price from the onehe paid (reflecting the difference between the prepaid price and spot price at timeof revocation, known by the Arabic name iqala). However, although revocationof salam sales is permissible, jurists did not allow settlement in cash either directlyor through revocation. In that context, classical jurists, starting with Abu Hanifaand his associates Abu Yusuf and Al-Shaybani, relied on a Prophetic tradition:“Whosoever engages in a salam contract, let him not take any replacement for thecontract’s specified price or object.”3 This Prophetic tradition disallows the longfrom accepting a replacement for the object of salam (e.g., financial equivalentat spot price) or from revoking the contract and receiving a replacement for theprice refund reflecting that financial equivalent at spot price. In other words, thiscanonical text appears directly to address the remaining ways in which financialengineers might try to convert the salam contract into a purely financial tool.

However, a minority opinion in the Maliki school allowed sale of the objectof salam prior to its receipt, provided that the object was not foodstuffs. In thisregard, if the object is sold to the original salam-short, they allowed the sale subjectto the condition that the price does not exceed the initial prepaid price. Indeed,in that case, one could characterize the second sale as a partial revocation of theoriginal sale (which is generally not accepted in the Maliki school, but acceptedin other schools),4 together with an exoneration of the salam-short’s remainingliability.5 Moreover, the Malikis permitted sale of the salam object prior to itsreceipt to a third party at any price, provided that the price is paid in a differentgenus, and the salam object was not a foodstuff. Those opinions also meant thatMalikis allowed settling the long position with the salam-short for an equal orsmaller amount.6

Parallel Salam

Since the Maliki school of jurisprudence does not have a significant following inthe areas where Islamic finance has witnessed its greatest growth, selling salamobjects to third parties was not the first method contemplated to utilize salam as apure financial tool. However, bankers and jurists found another juristic openingfor such utilization based on characterization of the salam-short position as debtfor the fungible salam object. Once it is characterized as debt for fungibles, theshort position may thus be forwarded to a third party, possibly within the contextof mutual debt clearance (maqassa). The most practical procedure devised alongthose lines by Islamic bankers came to be known as “parallel salam.”

This structure has allowed banks to use salam contracts to synthesize debts withfixed or variable interest rates as follows: Party A wishes to borrow $1,000,000 for


three months at LIBOR + 200 basis points, and party B is willing to lend himat that rate. Party A may take a short position to sell platinum, deliverable insix months to party B at a specified location, collecting the prepaid salam priceof $1,000,000. Three months later, the two parties may engage in a second andopposite salam contract, usually through a third-party intermediary to ensure sep-aration from the initial contract (as we have described in the case of tawarruq),for delivery of the same amount of platinum at the same location, with the pre-paid price being $1,000,000×(1+LIBOR+0.02). Then both parties have liabili-ties toward one another for delivery of the same amount of platinum at the samelocation, and the two liabilities may be canceled against one another according tothe rules of debt clearance (maqassa).

There are two main contemporary fatawa that pertain to this practice of parallelsalam.7 Notice the wording of requests for fatwa in the two cases. The questionerin the first fatwa asked directly about the permissibility of using this particularfinancial transaction (parallel salam) essentially as an institutionalized method forconventional banking practice. In this case, jurists ruled that, in fact, while thepractice was permissible on an individual basis in their opinion, it is not permis-sible to turn it into a business mode. However, that prohibition was promptlydiluted by the following appeal to considerations of competitiveness tantamountto necessity. Cleverly, the posers of the second fatwa question omitted askingabout making the practice a business mode. Also, the jurists in that second fatwaconveniently did not go out of their way to rule on the issue of systematic use,about which they were not asked.8

The first fatwa that we quote on parallel salam was the second fatwa of thesecond Dalla Al-Baraka Symposium:

Question:Is it permissible to sell the object of salam prior to its receipt?

If that is not allowed, is it permissible for the salam-long to take a salam-short positionin the same genus, based on his long position, but without linking the two contracts forwhat he is eligible to receive and what he is responsible to deliver?

Is it permissible for the salam-long to make this a systematic trade?

Answer:

1. It is not permissible to sell the object of salam prior to its receipt.2. However, it is permissible for the salam-long to take a salam-short position of the

same genus, without tying the first salam-long position by virtue of the first con-tract to the salam-short liability of the second contract.

3. It is not permissible to use this type of transaction [which was allowed in the secondparagraph of the answer] as a systematic mode of business. This is due to the fact


that salam was permitted as an exception to general legal rules, based on the needsof producers that can be met through salam in individual cases, without turning thelatter into a systematic trade. On the other hand, if economic conditions in someIslamic countries, and major benefit considerations, dictate using this methodologyas a systematic business mode in special cases, to minimize the effect of existinginjustice, then it may be permitted based on that major benefit, as determined byfatwa and Shari

˘

a supervisory boards.

The general prohibition of using this structure to synthesize interest-based debtinstruments in paragraph (3) was diluted substantially in the last sentence of thatparagraph. A second fatwa by the Shari

˘

a Board of Al-Rajhi Investment Corpora-tion (fatwa #41) indirectly appealed to that window of opportunity by invokingthe need for Islamic banks to be competitive with their conventional counterpartsin extending credit and being compensated accordingly. In the text of that Rajhifatwa, given below, the questioners tried to be less specific about their intent, butthe Shari

˘

a board in fact addressed the issue of synthesizing conventional bankloans in this manner, by appealing to the aforementioned need:

Question:Please inform us of the religious legal opinion regarding the Corporation’s purchase ofcommodities (such as crude oil, various metals, etc.) through salam contracts, with theprice being paid immediately, and delivery scheduled for a future date, knowing that theCorporation may sell that commodity through a salam contract, by receiving the price atthe time of the [second] sale, with delivery scheduled for a future date.

Answer:The main characteristic of the salam contract is that its object is a fungible liability mea-sured by volume, weight, size, or numbers of homogeneous commodities, including agri-cultural products such as grains, oils, and milk, industrial products such as iron, cement,automobiles, and airplanes, and raw or semiprocessed materials such as crude and refinedpetroleum.

It is permissible for the salam-long (buyer) after the inception of the contract and priorto the delivery date to act as a salam-short (seller) for a similar commodity, with similarconditions to the existing contract, or with different conditions. As described, the salamcontract is a highly efficient tool to meet the needs of an Islamic bank, recognizing that themain task of a bank is to extend credit, and its revenues rely primarily on the compensationit receives for time value.. . .

Since dealings in credit markets of advanced countries require facing severe and criticalcompetition, and since those countries provide a great deal of flexibility for competition,but put impediments for other tools of investment, this tool [salam contract] is considereda vital and important one to allow safe access to markets with flexible and wide competi-tion, while providing protection against customary risks in those markets, such as politicaland inflation risks.


The Rajhi Shari

˘

a board then proceeded to list five examples of using salamcontracts to finance trading in a variety of commodities, in most cases emphasiz-ing the real transaction aspect of salam. The Shari

˘

a board also listed the generallyaccepted Hanbali position to be permission of pawning or use of mortgaged col-lateral (rahn) and guaranty (kafala) in lieu of liability for the salam objects.

Those provisions allow Islamic financiers to use salam contracts to synthesizeinterest-based debt. In fact, applications of salam, for example, by the governmentof Bahrain in issuing short-term bonds known as sukuk al-salam, cut more cornersin settling the first salam for cash, as we shall see in Chapter 6. Those short-termdebt instruments (similar to treasury bills) pay a declared interest rates, and theyare backed by the full faith and credit of the issuing government. While thosesalam-based sukuk represented debt, and therefore were initially nontradable andmeant to be held to maturity, repurchase facilities were recently announced toenhance liquidity management of Islamic banks that are the primary buyers ofthose instruments. Details on how this repurchase facility worked are not readilyavailable, but it is clear how one could be constructed through the parallel salamvehicle described earlier.

Conventional and Synthesized Forwards

Classical jurists of all schools of jurisprudence forbade conventional forward con-tracts, wherein both price payment and delivery of sale object are stipulated asfuture liabilities.9 The primary reason they gave for the prohibition is gharar,citing in particular ignorance about the state of the object of sale at the specifiedfuture date. Thus, they argued, the price to be paid in the future is known, butthe future quality of the specified object of sale is unknown, which is a sourceof ignorance and uncertainty conducive to disputation. Recently Malaysian ju-rists, led by Dr. M. Hashim Kamali, have argued that legal and institutionaladvances, especially in organized futures exchanges, eliminate all excessive ghararfrom futures contracts by specifying in standardized contracts the characteristicsof objects of sale, as well as compensation formulas for various delivery optionsgiven to the futures-short.10 Consequently, they have allowed trading in Islamicfutures, where the only Islamic constraints pertain to, for example, the objects ofsale or margin trading rules.

In contrast, most jurists outside Malaysia remain opposed to forward and fu-tures trading.11 Some refer to the insistence of classical jurists of all schools thatthe price of salam must be paid in full at contract inception. Classical juristsargued that prepayment of the price (which gives salam its name) is the essenceof permissibility of the contract, to give farmers access to capital with which tobuy necessary inputs and sustain themselves until harvest. In addition, when the


price of salam is also fungible (e.g., monetary), those classical jurists argued thatdeferment of the price, while the object of salam is obviously deferred, would clas-sify the transaction in an explicitly forbidden category of exchanging one deferredliability for another (called bay

˘

al-kali˘

i bi-l-kali˘

).12 However, Malaysian andsome other jurists questioned the authenticity of traditions forbidding this type oftrade, many of them citing Al-Shafi

˘

i’s report that scholars of tradition consideredits chain of narration weak. Nevertheless, most scholars continue to reject forwardand futures trading, and many of them continue to quote that tradition as proof– especially those influenced by the Hanbali preference of traditions with weakchains of narration over any reasoning by analogy.

Thus, most jurists and Islamic finance practitioners outside of Malaysia ruledthat deferment of the price alone (in credit or installment sale) is permissible, as isdeferment of the object of sale alone (in salam sale), but deferment of both (con-ventional forward sale) is not permissible. This collection of rulings creates an-other Shari

˘

a arbitrage opportunity for synthesizing forbidden conventional for-ward contracts from the salam and credit sale contracts that jurists permitted.

Salam-

Short

Salam-

Long

Today: $1,000,000/(1+r)

In 1 year: platinum

Special-Purpose

Vehicle 1

Special-Purpose

Vehicle 2

Today:

platinum

Today:

$1,000,000/(1+r)

Today:

platinum

In 1 year:

$1,000,000

In 1 year:

$1,000,000

Today:

platinum

Today:

platinum

Today:

$1,000,000/(1+r)

Fig. 5.1. Forward Synthesized from Salam and Credit Sales

Figure 5.1 illustrates one possible structure for synthesizing a forward contractfrom salam and a credit facility for its price (characterized variously as murabaha,tawarruq, etc., depending on banker and jurist preferences). The combinationallows the salam-long to prepay the present value of the desired forward price.


For instance, if the desired contract was to pay $1,000,000 in one year for someamount of platinum, one could always convert it into a salam contract by pay-ing $1,000,000/(1+r) at contract inception, where r is the appropriate interestrate. In this regard, the salam-short may extend a credit facility to the salam-long,perhaps using tawarruq with the same platinum serving as the underlying com-modity, whereby the salam-long will obtain $1,000,000/(1+r) today (with whichto pay the salam price), for which he would have to pay the deferred price of$1,000,000 in one year (at the time he originally desired to make that forwardprice payment).

The detailed procedure can be implemented as follows, utilizing two special-purpose vehicles, to ensure that no two parties ever engage in more than one tradeof platinum with each other – thus minimizing concerns based on the prohibitionof

˘

ina sales:

1. Salam-short sells platinum to SPV1 on credit, for $1,000,000 payable inone year. This is a standard credit sale transaction.

2. SPV1 sells platinum to Salam-long on credit, for $1,000,000 payable inone year. This is also a standard credit sale transaction.

3. Salam-long sells platinum to SPV2, for a cash price of $1,000,000/(1+r).This is a standard spot sale.

4. SPV2 sells platinum to Salam-short for a price of $1,000,000/(1+r). Thisis also a standard spot sale.The net result of steps 1–4 is a tawarruq facility whereby Salam-longreceives $1,000,000/(1+r) today (through SPV1) and owes Salam-short$1,000,000 in one year (through SPV2). Finally,

5. Salam-long uses the $1,000,000/(1+r) as a prepaid salam price, which hepays to Salam-short.

As a result of this salam contract, Salam-short owes Salam-long platinumdeliverable in one year. In the meantime, Salam-long owes Salam-short$1,000,000 to be paid in one year. This is the forward contract we wishedto synthesize.

This structure ensures that each entity does one and only one transaction witheach other entity, hence avoiding any problems with same-item sale-repurchase(

˘

ina). This separation also allows the long and short to gain approval from Shari

˘

aboards for all components separately, thus avoiding potential prejudice againstsynthesizing a forward position. Depending on the Shari

˘

a board or boards ofthe short and long, transaction costs can be further reduced, according to thetawarruq conditions imposed by those boards, which determine transactions costs


of that component of our structure. In Chapter 10 we shall discuss the use ofsimilar synthetic forwards to synthesize options, short positions, and the like.

It might appear that this proposed structure merely replicates classical formsof Islamic financial transactions, while adding no contribution to substance. Ofcourse, based on the track record of Islamic finance, that would be the most likelyutilization for this and similar contrived structures. In fact, however, the same“marking to market” logic utilized in Chapter 4 can ensure that the suggestedstructure – at least as a counterfactual that is not in fact implemented – addssubstance. In this regard, arbitrage pricing of forwards, as taught in all financetextbooks, will force forward participants who contemplate using the salam con-tract to engage in a beneficial calculation. The arbitrage pricing logic for forwardsproceeds as follows:

• Consider two portfolios: (1) a long forward contract plus the present value ofthe specified forward price (discounted at the riskless interest rate r), and (2) along position for goods to be delivered at the same future date specified in theforward contract.

• Notice that the second portfolio is precisely the liability on Salam-short towardSalam-long after full payment of the salam price at contract inception.

• Obviously, one can invest the present value of the forward price at the risklessrate (e.g., in treasury bills), thus converting the first portfolio into the second.In other words, if there are no other risks, the two portfolios must have equalvalues at delivery time.

• Since no risk is being taken between contract inception and delivery time, andsince the two portfolios are equal in value at delivery time, they must also beequal in value at contract inception time. In other words, the salam price willbe correct if and only if it is equal to the present value of the forward price: Ahigher salam price would unjustly favor the seller and vice versa.

Consequently, as we argued in the case of property purchase financing, the cal-culus imposed by our structure forces the parties through a “marking to market”exercise, which in turn ensures that trading will not take place at unfair prices.Needless to say, performing the calculations to ensure proper pricing does notrequire actually engaging in multiple inefficient trades. This structure may beused merely as a legal fiction to ensure proper pricing, without actually realizingthe efficiency losses associated with multiple trades and corresponding transactioncosts.


5 .2 Commission to Manufacture (Istisna‘ )

Classical jurists approved another contract to purchase some item that is generallynot owned by the seller at contract time, and that may never have existed priorto the contract. Under this contract, generally known as istisna

˘or commission

to manufacture, the buyer (known as mustasni

˘

or commissioner to manufacture)pays the price either in one or multiple installments, and a liability is establishedon the worker/seller (known as sani

˘

or manufacturer) to deliver the object of saleas described in the contract at some future date.

Thus, istisna

˘

shared with salam the function of financing the production ofnonexistent items, which are established as liabilities on the sellers. However,istisna

˘

differed from salam in a few main respects: First, jurists did not requireprice in istisna

˘

to be fully paid at contract inception, to facilitate the financingof multistage manufacturing or construction projects, wherein the buyer may payfor each phase separately. Second, the term of deferment in salam is prespecified,and the seller must therefore acquire the object of sale at the specified deliverytime on the spot market if he fails to produce it – prompting jurists to list asalam condition of general availability of the object of sale at delivery time. Incontrast, the object of istisna

˘

may never come into existence except by virtue ofthe istisna

˘

contract. Hence, the term of deferment in istisna

˘

need not be fixed atthe inception of the contract.

Third, although the object of a salam sale is fungible (e.g., metals or grains),the object of an istisna

˘

sale is typically nonfungible (e.g., a freeway or building).Fourth, salam contracts are binding on both parties and thus may be voided onlyby mutual consent. In contrast, istisna

˘

contracts were deemed nonbinding oneither party by early classical jurists. However, later jurists made the contractbinding on both parties, and that opinion was codified in the Hanafi Majalla andadopted in the AAOIFI standard.13 That standard also chose a minority opinionthat requires the term of deferment in istisna

˘

to be specified, provided that amutually agreeable term is selected, allowing sufficient time for the necessary workto be done.

Some classical jurists debated whether the object of an istisna

˘

contract is theobject to be manufactured or the manufacturer’s labor/effort. If the contract ismerely the sale of an object to be delivered in the future, it would be no differ-ent from salam. Conversely, if the contract was merely over the manufacturer’slabor, it would be an employment or hire contract, as discussed under the rulesof ijara contracts in Chapter 6. Either characterization by itself would deem thecontract impermissible based on analogy, since sales of nonexistent properties aregenerally forbidden (salam being an exception), and hiring contracts require thatthe employer must provide raw materials.14

5 .3 Down-Payment Sale (‘Urbun) 91

Jurists of the various schools finally reached a compromise characterization ofthe contract, stipulating that the object of istisna

˘

is the sold object, but that thecontract requires the one commissioned to manufacture that object of sale to ex-ert effort in its production. Moreover, contemporary jurists stipulated that if thecontract did not require the commissioned party in istisna

˘

to do the work him-self, he may subcontract the work to another through a second istisna

˘

contract.This practice of the commissioned agent engaging in a second istisna

˘

contractcame to be known as parallel istisna

˘

. In parallel istisna˘

there is no direct liabilityon the final worker toward the initial commissioner/buyer, thus keeping the twocontracts separate.15

The istisna

˘

contract is most commonly used in conjunction with a lease (ijara)contract, thus giving rise to a BOT (build, operate, transfer) structure for financ-ing infrastructure development and similar large projects. The Islamic Devel-opment Bank has been particularly active in utilizing this contract for financinginfrastructure projects in various member countries. Because of the specific na-ture of this contract, it has not easily lent itself to pure financial applications, thusremaining a tool for real project financing. On the other hand, some advances insecuritization have expanded its uses in synthesizing Islamic sukuk, as discussed inChapter 6. In general, project finance structures based on istisna

˘

differ very littlefrom their conventional counterparts.

5 .3 Down-Payment Sale (‘Urbun)

In its classical manifestation,

˘

urbun was a down payment from a potential buyerto a potential seller toward the purchase of a particular property.16 If the buyerdecided to complete the sale, the

˘

urbun counted toward the total price. Other-wise, if the buyer did not execute the sale, he forfeited the down payment, whichwas thus considered a gift to the seller. Naturally, contemporary jurists and Is-lamic financial practitioners contemplated the similarity of this arrangement toa call option, which is likewise binding on the seller but not on the buyer. In-deed, some classical Hanbali jurists had even contemplated that the option periodshould be fixed (making the transaction somewhat similar to an American calloption), otherwise the seller may have to wait indefinitely for the potential buyerto decide whether or not to exercise his right.17

Classical jurists differed over the legal status of this contract, most of them for-bidding it based on a Prophetic tradition (which referred to the transaction underthe name bay

˘

al-

˘

urban). Although that tradition was deemed nonauthoritative,because of missing links in its chain of narration, most classical jurists still deemedthe contract forbidden, because of gharar, since the seller does not know whetheror not the buyer will conclude the sale. Moreover, they argued, the potential seller


gives the potential buyer in this contract an option (in contemporary parlance: acall option), but if the buyer proceeds to exercise that option, the down paymentcounts toward the price, and the seller would thus not have been compensated forthe option.18

This argument is particularly interesting, since classical jurists (and most con-temporary ones) forbid the sale of naked options (because of gharar, accordingto the same logic as before), and since most of them do not consider mere le-gal rights (e.g., to exercise an option) to be valid objects of sale. However, thosesame classical jurists clearly felt that an embedded option (as in the case of

˘

urbun)should be properly compensated. It is in this regard that they ruled that the selleris compensated only if the buyer did not exercise his right, and even that may notbe sufficient compensation for the time he had to wait, during which he was notable to sell the property and benefit from its price.

In contrast to the majority of jurists of his time, Ahmad ibn Hanbal deemed thepractice of down-payment sales permissible. He relied on a Prophetic tradition:“The Messenger of God was asked about down-payment sale (al-

˘

urban), andpermitted it.”19 Interestingly, scholars of tradition consider this also a traditionwith a weak chain of narration. However, this narration was further supported byanother weak narration that

˘

Umar ibn Al-Khattab allowed down payment towardthe purchase of a jailhouse. Moreover, classical Hanbali and contemporary juristsof most schools argued that down-payment sales had become very common andprovided some compensation to the seller for waiting, in case the buyer decidesnot to execute the sale. Moreover, contemporary jurists argued, there are weakProphetic traditions that provide support either for permission or for prohibition.Hence, the Fiqh Academy of the Organization of Islamic Conference (the mostprestigious international juristic body) ruled at its eighth session in Brunei in 1993that down-payment sales are permissible.

‘Urbun as Call Option

Most analysts of the differences between the down-payment sale (

˘

urbun) andcontemporary call options concluded that the latter cannot be synthesized fromthe former.20 On the other hand, a number of institutions have been in fact usingcall options under the name

˘

urbun, ignoring some of the finer legal differencesbetween the two contracts. For instance, if a seller wishes to write (sell) a calloption to a potential buyer, giving him the right to buy within the specified timewindow at a strike price of $100, and sell that call option to the potential buyerfor $c, one may call $c a “down payment” and inflate the agreed-upon price inthe down-payment sale to $100+c. Thus, if the option holder decides not toexercise the option, he would have paid the premium $c, and if he does exercise

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